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Factor investing, or sometimes called smart beta, is a relatively new investment strategy for most retail investors. In our previous article, we introduced the 3 Fama-French factors that have been proven to explain and predict stock returns.
Even before the Fama-French paper was written, the market risk, size, and value factors have already been implemented in different names. In this article, we will discuss why these 3 factors have persisted throughout the years and are still so popular today.
The market risk factor is simply a strategy that buys the market index. Beginners in investment are often encouraged to just ‘buy the market’, frequently through low-cost broad-market ETFs. Such strategies do well in the long run because the investment is well-diversified, and it costs very little to implement and maintain. Other benefits include a stable and predictable return in the long term.
However, the trade-off with just holding the market portfolio is that you may not get extremely high returns, so this may not sit well with investors who are willing to take higher risks. Another issue is that even though the returns are fairly stable, there could be economic recessions every decade or so that can cause stock market crashes.
Unless you are invested over a long period of time, buying at the high before the crash and selling at the low during the crash could hurt your returns immensely.
The key thing here is to find a low-cost broad market index fund that has low fees (1% or less), and stay invested for about 20 years or more. Such a method will allow returns to compound, and it ignores the short-term volatility in the markets.
The value factor is one of the oldest factors (or company attributes) that is still being recommended to investors. Endorsed since the 1930s, it essentially advocates looking for cheap stocks, with its most common form using a company’s P/E or P/B ratios.
By buying stocks with the lowest P/E or P/B ratios, investors hope that the market will recognize the low prices of these stocks and bid them up over time, earning the early investors a good return.
Implementation of the value factor has evolved from Fama-French’s strategy, of buying high Book-to-Market (inverse of P/B) and selling low Book-to-Market, to recent times where investors look at Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) / Total Enterprise Value (TEV).
The recent results seem to show that EBITDA/TEV is more efficient in identifying companies that subsequently gave good returns.
The key problem with the value factor is this – low price may not mean high quality. Just buying the cheapest stock may result in the investor buying bad companies. The low price could be due to a poor industry outlook or financial troubles that such companies may be facing.
One of the ways to solve this problem is to first filter out companies with attributes that may indicate poor performance. For example, companies with high accruals in their financial statements may indicate some form of earnings manipulation. Such manipulation is legal but may signal weak operating cashflow, which is key to strong stock fundamentals.
The size factor is the belief that companies with smaller market capitalization or asset size will outperform larger companies. Smaller companies are usually younger companies that can potentially grow much faster than their bigger counterparts.
Such growth gives rise to larger ‘home run’ returns. Investors often like to brag about how they picked a young and unknown stock which miraculously gave them 10 to 15 times returns on their investment within a span of a few weeks or months. Such is the lure of the size factor.
The problem with such a strategy is that small companies can stay small, and they often do. The odds of picking a small company that yields 10 to 15 times consistently without any private information may be similar to buying the lottery.
Small companies also suffer from liquidity issues – it is difficult to find buyers to buy these relatively unknown companies from you. Stock prices of smaller companies are often very volatile, making selection and timing for buying and selling a tricky issue.
Even though selecting a fund that is exposed to the size factor can help alleviate some of the problems (liquidity), the size factor, on the whole, is not the best single factor you will want to be invested in.
It is a trick question as the answer is to use all 3 factors together. Pick the group of cheapest, small companies that are highly exposed to market risk, and you should have the best chance of reaping investment rewards.
However, except for the market risk factor, the 2 other factors have been known to work only during certain periods. For example, the value factor usually does not work well during boom periods because the entire investment community is too busy chasing growth stocks. Holding value stocks may mean you have to wait a long time before the market recognizes their worth.
If you want to be safe, just investing in the market risk factor will preserve and grow your capital, while having long-term exposure to the value and size factors will boost returns.