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LOOK AT THE STOCK market, and you’ll see that certain stocks often do better than others. Technology shares have been standout performers over the past 10 years, and health care stocks have done very well.
But research has also found that certain types of stocks have done better than others. Smaller-company stocks, for example, have outpaced those of larger firms. In the academic literature, characteristics like this, which are correlated with outperformance, are known as investment “factors.” More than 100 such factors have been identified. Below is a brief history of factor investing and thoughts on how you might—or might not—incorporate factors into your portfolio.
In 1992, Eugene Fama and Kenneth French, colleagues at the University of Chicago, documented two factors that had a clear correlation with stock-market outperformance: small-cap and value. This research was broadly accepted, in large part because it was supported by intuition. It’s easier for smaller companies to grow more quickly, percentage-wise, than larger companies. And it makes sense that value stocks, which are cheaper, have more room to appreciate than those that are already expensive.
Factor investing is far from perfect, though. The Fama-French factors have sometimes lagged for long stretches. Value stocks, in fact, have lagged their growth peers by a cumulative 75 percentage points over the past 10 years. Similarly, small-cap stocks have an uneven track record. Last year, when the S&P 500 index of large-cap stocks dropped 18%, smaller stocks lost 26%. Factor investing, it turns out, requires patience—lots of it.
Even if you have the patience to stick with an investment factor over the long term, research has shown that good ideas often sow the seeds of their own demise. In a well-known paper from 2012, researchers David McLean and Jeffrey Pontiff looked at this question. Their study was titled, “Does Academic Research Destroy Stock Return Predictability?”
McLean and Pontiff examined dozens of stock market factors. What they found is that factors tend to have a limited shelf life, with performance advantages dissipating over time. Why? When a new factor is identified—and publicized—other investors tend to pile into that investment. That can drive up its price. If enough people do that, the opportunity to outperform with that investment will fade because the price has already risen. Investors talk about an advantage being “arbitraged away.”
The lesson for investors: Factors aren’t permanent. If you do decide to tilt your portfolio in favor of one factor or another, I wouldn’t go too far—because what worked yesterday might not work tomorrow.
Another obstacle to implementing factor strategies: They tend to be tax-inefficient. Because factor investing involves picking and choosing stocks, it can require frequent trading, and that trading can mean big tax bills. Thus, if you choose to incorporate some factors into your portfolio, try to do it in a tax-deferred account.
Another oddity of factor investing: Certain factors stand in direct contradiction to others. Momentum stocks, for example, are stocks that have recently been trending higher. They’ve been shown to exhibit outperformance. But so have value stocks, which are stocks with lagging share prices. In other words, they’re the opposite of momentum stocks, and yet they’ve also exhibited outperformance. This inherent contradiction doesn’t make a lot of sense, and it’s a reason many investors are skeptical of the entire idea.
Even professional investors who work to exploit factors don’t find it easy. In The Man Who Solved the Market, Gregory Zuckerman looked at Renaissance Technologies, the hedge fund with arguably the best track record in the industry, returning an average 39% a year over 30 years. But that success was hard won. Even with all its expertise and resources, a Renaissance employee once commented that only 50.75% of the firm’s trades were successful—an awfully thin margin.
In the end, after Renaissance fully cracked the code on factor investing, the firm returned all outside shareholders’ money. Today, even if you wanted to invest in Renaissance, you couldn’t. The bottom line: These strategies are extremely difficult to implement, and the firms that do it best aren’t easy to access.
In fairness, you don’t need to build a Renaissance-like computer model to identify winning corners of the stock market. As I noted earlier, certain industries have demonstrated strong performance. It would be easy to buy index funds that covered those specific industries, so it might seem like an easy solution would be to build a portfolio that simply overweighted these winning corners of the market.
While that might seem logical, there are flies in the ointment with even this simple idea. Perhaps most significant is that sectors move in cycles—sometimes outperforming and sometimes underperforming—and these cycles are erratic. Consider the energy sector. Over the past 20 years, the oil market has swung between two extremes. In the late-2000s, many believed in “peak oil,” the idea that the world was running out of oil. Oil prices peaked in 2008 at $145 per barrel. In the years after the financial crisis, though, electric cars became more of a reality, and oil prices sank.
Still, it hasn’t been a straight line. Last year, largely because of Russia’s invasion of Ukraine, oil prices rose, and the energy sector was the top performer in the S&P 500, gaining 67%. This year, however, despite the ongoing war, prices have moderated, and year-to-date energy is the worst sector, down 7%, while the overall market is up 8%. In other words, you might have a long-term thesis on an industry—and you might be right—but in the short term, things could easily go in the other direction.
It’s not just energy. Every sector has its own dynamics. Banks, for example, are steady moneymakers in good times. But as we’ve seen this year, shifting interest rates—combined with mismanagement—can drive them into insolvency. Health care stocks have been the second-best performers in the S&P 500 over the past 10 years. But the government and insurers hold so much sway that it’s hard to know whether these stocks will be as profitable over the next 10 years. No sector is flawless.
For these reasons, it’s difficult to know which corners of the market will be leading the way at any given time. That’s why, in building a portfolio, I recommend trying to stick closely to a total-market approach. You could include some small factor overweights—personally, I include small-cap and value—but I would do that only in the most modest way. Vanguard Group founder Jack Bogle said it best: “Don’t look for the needle in the haystack. Just buy the haystack.”
Should investors tilt toward growth or value? Offer your thoughts in HumbleDollar’s Voices section.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.
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Thanks for this excellent (as usual!) post Mr. Grossman.
Something else I’d be curious to hear you weigh in on is the greatly increased dependence of “total market” funds on a handful of tech companies (the so-called FAANG stocks). Ben Carson posted about this recently and the table showing the companies driving returns and their share of the S&P 500 is quite striking:
https://awealthofcommonsense.com/2023/05/concentration-in-the-stock-market-2/
So it seems to me that one of the arguments for including a fairly substantial slice of small-cap value is not so much the expectation that it’ll out-perform but wanting to have more of a true total market stock portfolio whose results don’t depend on the fates of a few tech firms. This is of course the DFA/Paul Merriman argument and is well-supported by historical data – provided one can overcome very understandable recency bias caused by U.S. mega-cap firms’ soaring outperformance over the past ~15 years.
Thanks Adam, this is the clearest explanation of factor investing that I’ve come across, and I appreciate the references to the academic papers that you cite. I agree that having most of one’s portfolio in total market index funds, with some small factor overweights, is a smart way to go. For me, that means most of my equity positions are in VTSAX and VTIAX, with about 5% each in sector index funds … VSIAX (small cap value) and VEMEX (emerging markets) … both of those are in my Roth account, which should be my very longest term holdings.
One question … would international be considered a “factor” in the sense that you describe?
As long as I’ve followed the market, everyone has been looking for a simple way to determine which companies will flourish. From Ben Graham to Peter Lynch to Jack Bogle, everyone has a theory on the best way to invest in the market.
But what does it take to be highly successful? Like Warren Buffett, you have to devote yourself to in-depth research. Buffett reads 10-K reports from cover to cover, including the footnotes. He has spent his life researching companies and industries, and as a result has been highly successful.
Interesting article Adam. Very good work. But the last sentence is the most important.
+1 for value and small, on US and ex-US. Have you seen any research on “quality” or dividend appreciation ?