Can a dose of “factors” boost your returns?

Investor’s dream: You score companies on a simple formula involving their finances. You buy the good ones. You beat the hell out of the market.

People have been trying to do this for as long as computers have been around. Now comes Vanguard, the titan of index investing, with a scheme to beat the indexes. It has just joined the large Wall Street mob using “factors” to enhance performance.

This guy noticed the quality factor before you did (Daniel Zuchnik/WireImage)

A factor is a financial attribute that is supposed to make stocks that have it do better than ones that don’t. One desirable factor is low volatility. Sleepy stocks, so the theory goes, outperform volatile ones. Another factor goes by the name “quality.” Quality companies are the ones with strong balance sheets and high profit margins. Their shares also, it seems, beat the averages.

If you buy into this and you are getting restless with your index funds, Vanguard will sell you what you want. You can, for a slightly higher management fee than you’d pay on an index fund, switch to one of Vanguard’s new factor specials. Besides the low-vol and quality factors, you can tilt your portfolio towards value (stocks priced at comparatively low multiples of earnings or book value), momentum (stocks that have done well recently) or illiquidity (stocks that trade thinly).

For a still higher fee, Vanguard will let you in on the deluxe version of factor investing. Its multifactor fund scorecards stocks on four factors at once (all but the illiquidity).

Is this a way to beat the market? There’s no question that it was a way to beat the market. You could have handsomely outperformed a pure indexer over the past 30 years by owning a portfolio of stocks scoring high by any of the five factors Vanguard is using.

But now? When you buy into a factor today, you’re going to have a lot of company. Morningstar puts factor funds into a group it calls “strategic beta,” by which it means mechanically harvested portfolios with some weighting other than the traditional one of market value. Counting only U.S.-listed exchange-traded funds and exchange-traded notes, Morningstar toted up 650 strategic-beta products with $622 billion in assets as of last June. Assets had climbed 27% from the year earlier.

A low-vol fund gives you more of sleepy Microsoft (MSFT) and Home Depot (HD) than you would get in an S&P 500 index fund. No question, these two are stocks you wish you had bought 20 or 30 years ago. But do you really want to be piling into them now, when every other low-vol player is doing the same? Aren’t these stocks are a bit overbought?

Not necessarily, says John Ameriks, who runs Vanguard’s quantitative equity operation. “We think these [factor] strategies are enduring and going to be around for decades to come.”

He might be right. Perhaps all five of the factors that would have enhanced your wealth since 1988 are destined to do the same through 2048. But for that to happen, investors today would have to be making the same mistakes they made in the past.

Consider the quality angle. Nvidia (NVDA) and Mastercard (MA) qualify for a quality-tilted portfolio. They are certainly nice things to have bought a while back. Now they are anything but bargains, trading, respectively, at 51 and at 48 times trailing earnings.

Hindsight enables us to see that in past decades investors collectively failed to appreciate quality. Given two companies with similar earnings and growth, one possessing valuable brands and fat margins, the other not, Wall Street should have assigned a higher valuation to the former.

Warren Buffett did not make that mistake. He went for the brands and the other things that surround some businesses with what he called an economic moat. And now “moat” is a cliché, found in every fund and company write-up at Morningstar. Recent headline there: “Volume Continues to Grow at Wide-Moat Mastercard.”

If I had to pick one factor to be an enduring winner, it would be value. Investors questing for the next Amazon overpay for growth. They keep doing that even though they have been admonished, going back at least as far as the 1934 edition of Graham and Dodd’s Security Analysis, to buy the less interesting companies trading at low multiples of earnings and book value.

But even on this score, I harbor doubt. Six years ago I published a review of a strategic-beta fund from Robert Arnott’s Research Affiliates, PowerShares FTSE Rafi U.S. 1000 (PRF). The fund aims to improve on index investing by weighting companies according to measures like book value, sales and cash flow rather than according to market value.

The Rafi fund is not precisely a value play, but there’s a lot of overlap. An S&P 500 index fund has less money in value-stock Exxon Mobil than in growth-stock Amazon; the Rafi fund has five times as much in Exxon as in Amazon.

My story did not sit well with John C. Bogle, founder of Vanguard, creator of the retail index fund and a dogmatic believer in market value weighting. Shortly after it appeared he collared me at a symposium and scolded me for making favorable comments about the Rafi fund. There will be stretches when Rafi runs ahead, he said, but then stretches when it falls behind. Over the long run, it will do no better.

It looks like Bogle was right. Over the five years ended Feb. 23, 2013, Rafi beat conventional indexing by 1.8 percentage points a year. Over the five years since then, it has fallen behind by 1.7 points a year.

What do I say to people craving strategic beta? Don’t smoke, but if you do smoke, smoke low-tar cigarettes. Get a cheap factor fund. The table displays several.

Factor fundsForbes

Linking to:

Morningstar survey of strategic beta

Fidelity research on factor returns

Vanguard research on illiquidity

Famous Fama-French paper on factors

Originally published at Forbes

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