Is factor investing worthwhile? The best 5 factor premiums in the yield check

In this article, we look at what factor investing is, which factors have generated particularly high returns in the past and what the main advantages and disadvantages of this investment strategy are.

What does factor investing mean?

Factor-based investing, smart beta investing or simply factor investing is an investment strategy that focuses on securities with certain characteristics (so-called factors). These factors have provided investors with higher returns in the past. This is confirmed by numerous scientific studies, often based on periods of several decades.

Factor-based investing is therefore the overweighting of factor premiums in a portfolio compared to a market-neutral weighting. The market-neutral weighting reflects the overall market or “all” shares according to their market capitalization. It is the classic or original form of all passive investment strategies.

When is a factor premium involved?

Financial author Larry Swedroe and other experts have identified the following seven criteria:

1. Confirmation from at least several dozen independent scientists
2. High stability, i.e. over several decades (the more evenly distributed the factor premium, the more convincing)
3. Global verifiability, i.e. not focused on specific countries or sectors
4. Clear filter criterion, i.e. no adjustments in the definition of the factor premium
5. Cost-efficient exploitation of the factor premium, i.e. a factor premium should also result after costs
6. Comprehensibility, i.e. it is based on a logically plausible explanation
7. Uniqueness of the factor premium, i.e. no mere variation of an existing factor premium

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Gerd Kommer also mentions the following characteristics of factor premiums in his ETF standard work “Souverän Investieren mit Indexfonds und ETFs”, which is well worth reading:

• Factor premiums can fluctuate greatly and cannot be reliably predicted in the short and medium term.
• Factor premiums are not “additive”: it is therefore not possible to add up the sum of all individual factor premiums in a multi-factor portfolio.
• Most factor premiums become weaker after their scientific discovery, but often still high enough to result in an excess return after costs.
• Factor investing incurs higher costs than comparable simple ETFs.
• Factor investing only works statistically or according to the law of large numbers and not on an individual value basis.
• Factor investing is compatible with the Efficient Market Theory (EMT).
• Factor investing can be described as a more “active” variant of “passive” investing. The main characteristics of “passive” such as cost minimization, buy-and-hold, strict scientific orientation, mechanical rule-based approach and rigorous avoidance of conflicts of interest still apply.

The most important factor premiums for equities

The five best scientifically proven factor premiums in the “equities” asset class are presented below. To illustrate this, reference is made in each case to the corresponding factor-specific MSCI index and the price performance over the last 15 years is compared with a more market-neutral index, usually the MSCI World, as a benchmark. The scientifically confirmed excess returns of the individual factors are discussed in Chapter 4.

Small-size premium

The small-size effect states that small stock corporations (second-line stocks) have statistically higher returns than large ones. The market capitalization or stock market value of a company serves as the basis for the calculation. The index manufacturer MSCI defines the size ratios as follows: The largest companies, which account for 70% of the market capitalization of an index region, are large caps. The next 15% are mid caps. A further 14% are small caps, while the remaining 1% are micro caps. The median market capitalization of a small cap according to the “MSCI World Small Cap” index was around USD 853 million in August 2020.

In other words: Only those who have more than 14% small caps in their portfolio can speak of a factor-based investment. This is because 14% corresponds to a market-neutral weighting.

Largest position in the “MSCI World Small Cap Index” as at 31.8.2020: Horizon Therapeutics

Value premium

Value stocks in an academic context (and not stock-picking à la Warren Buffett) have a particularly low share price relative to their fundamentals. This undervaluation is usually determined on the basis of the price-to-book ratio (P/B ratio), the price-to-earnings ratio (P/E ratio), the dividend yield and the free cash flow.

Largest position in the “MSCI World Value” as at 31.8.2020: Johnson & Johnson

Momentum premium

Stocks that have outperformed the market in the past also show higher returns in the near future. In simple terms, this is the basic reasoning behind the momentum premium. It is therefore based on relative returns and, according to the “MSCI World Momentum Index”, comprises shares that have outperformed the market in the last 6 and 12 months.

Largest position in the “MSCI World Momentum” as at 31.8.2020: Apple

Quality premium

Quality stocks have low debt, stable earnings, continuous asset growth and strong corporate governance. They are therefore high-quality shares based on common financial ratios such as return on equity (ROE), debt-equity ratio (D/E; dept to equity) and earnings variability.

Largest position in “MSCI World Quality” as at 31.8.2020: Apple (again)

Political risk premium

This factor premium relates to equities from emerging markets or emerging countries. It is essentially explained by compensation for a higher risk resulting from political instability, corruption or an inadequate legal system or a lack of separation of powers, among other things.

Largest position in the “MSCI Emerging Markets” as at 31.8.2020: Alibaba

How do the five factors perform?

The only, but significant advantage of factor investing is the excess return. This also applies – in the (very) long term and to varying degrees – to our five factors described above. The table below shows the excess return per factor and over different time periods.

Figure 6 shows the following interesting aspects:

• Value and small-size have been studied most thoroughly and over the longest periods of time.
• The fluctuations are sometimes considerable. Between 2009 and 2018, for example, political risk stocks posted a return of 0.3%, whereas a decade earlier they had outperformed by an incredible 12.8% a year.
• The rather little-known momentum premium is by far the most attractive at 4.3% over a 24-year period. At the other end of the spectrum, the much better-known value factor achieved a meagre 0.1% additional return.

What are the disadvantages of factor investing?

But before you decide on factor investing, you should also be aware of the main disadvantages.

All five factors listed above have the following disadvantages:

• Higher costs (TER), even if prices have fallen sharply in recent years
• Small product range and relatively few factor ETFs
• Longer stretches of return than with a market-neutral investment require a greater degree of suffering and stamina

The following aspects also have a negative impact on the value factor

• No discernible excess return in the last three decades (!), especially after costs
• above-average tax burden for CH investors, as the distributive share of total performance is higher for value stocks than for the market as a whole and for the other four factors (see article Dividenden-Strategie lohnt sich nicht! 3 grosse Nachteile für Schweizer Anleger )

Conclusion

We summarize our conclusions in the following five points:

1. Factor investing can lead to an excess return in the long term and is generally worth considering, but is not a must.
2. A simpler and cheaper alternative to factor investing is and remains an investment in the market as a whole.
3. We prefer the small-size, political risk, momentum and quality factors to the value strategy. According to the video below by Gerd Kommer Invest, “value” is not yet dead and may even be about to make a comeback. For tax reasons (for Swiss investors), however, it is not an issue for us. In addition, the dry spell in terms of the lack of excess returns is a little too long for us.
4. The range of factor ETFs is relatively small and the prices are higher than for “normal” ETFs. As an investor, you should take these aspects into account.
5. The excess returns for the five factors examined have been scientifically confirmed by numerous studies and over long periods of time. However, there is no guarantee that this will also apply in the future. In any case, you have to be prepared for long dry spells with factor investing.

This might also interest you

Informative video on the topic of “Factor Investing” by Gerd Kommer Invest:

Disclaimer

Disclaimer: Investing involves risks of loss. You must decide for yourself whether you want to bear these risks or not.

Errors excepted: We have written this article to the best of our knowledge and belief. Our aim is to provide you as a private investor with the most objective and meaningful financial information possible. However, should we have made any errors, forgotten important aspects and/or no longer have up-to-date information, we would be grateful if you could let us know.