Factor Farming and the Value of Perspective

Advanced, Theory

An interesting recent trend I’ve noticed in portfolio discussions is a renewed debate about the resilience of factor premiums versus the good old cap-weighted stock market. It’s entirely predictable that a tough stretch for any investment has a way of bringing out both the nervous supporters on one side and the proud haters on the other. But I really can’t fault the pros for keeping an eye on performance of some of the trendier factors or the investing laypeople for wondering what everyone is even talking about.

What do I think? It’s complicated. So let’s talk about factor investing.

For the uninitiated, “factors” are various investment filters that academics have identified which historically have helped boost returns. You may also have heard the term “Smart Beta”, which is really just an impressive sounding marketing name for the same concept. There are a ridiculous number of factors out there that lots of smart people have studied looking for an edge, and some of the most prominent and widely accepted are things like size, value, momentum, quality, and volatility. I won’t go into every one, but two should sound very familiar as small and value feature prominently in many of the portfolios here on the site. So if small cap stocks or value stocks no longer work as advertised, that has some pretty significant implications on what portfolio you might choose.

The thing about factors that I think a lot of people misunderstand is that they’re definitely not a law of nature that always works. If small caps always provide superior returns to large caps, nobody would invest in large caps. Like any investment discussion there’s some natural uncertainty involved, and the most that prominent factor researchers like the professor duo of Eugene Fama & Kenneth French will ever claim is that certain factors worked more often than not and were caused by something other than chance.

As a result, most people who are really into factor investing rarely place bets on only one factor alone. Instead, they talk about diversifying factors. Since a factor is really a filter, the idea of diversifying factors may be a little strange to people who normally think of diversification as the process of increasing stocks in a portfolio rather than decreasing them. But the idea really isn’t that unusual if you think of factors as potential helpers. When you know of more than one thing that might help to weed out problem areas, doing them all generally increases your chances of getting a good result.

The issue that seems to have some investors in a tizzy is the recent poor performance of small cap value relative to standard large cap blend. With two of the most popular factors in combination not only under-performing the market as a whole recently but notably fading in effectiveness over the last 15 years, some people have started to wonder if something changed. Does factor investing still work? And what does that mean for our portfolios? To explain how I feel about it, let’s ditch the financial stuff for a moment and talk about something close to my heart — food.

Factor investing is like growing the perfect carrot.

Smart food science researchers spend countless hours studying the history of carrots to unravel every factor involved in growing a better carrot.  They identify all the right genes to modify to make it grow quickly and resist damaging pests.  They find just the right soil with the best combination of acidity and nutrients.  They import the perfect water source and quantify the ideal irrigation rate.  Taken together, these factors are proven to make a better carrot more often than not. 

In fact, it would not surprise me if researchers have statistically determined that the success of all the best award-winning carrots can be attributed to some combination of those factors.  The methodology is quite rigorous, and educated farmers on top of the latest research can diversify across all the best carrot factors to maximize the likelihood of growing a terrific carrot.  While there will always be some luck involved and not everyone is guaranteed to walk away with the blue ribbon at the fair, more often than not it works! 

To illustrate the power of factor farming in investing, here’s a chart made using the Portfolio Finder that shows the performance of every possible combination of up to 5 of large, mid, and small cap blend and large, mid, and small cap value index funds in the US. You can think of it as a way to quickly evaluate a bunch of different portfolios with varying small and value factor exposures all at once. The smaller and more value-oriented the portfolio as a whole, the closer it is to a pure small cap value fund.

A very important point here is to note that the axes use metrics that are designed to be timeframe independent. As we discussed earlier, factors don’t always work over every timeframe. So rather than highlight the recent hot streak of one portfolio against the under-performance of another, this chart studies every investing timeframe since 1970 simultaneously and shows the real-world mediocre returns for every portfolio. It’s what they look like when they first roll out of bed with no cherry-picked Instagram-ready selfie for marketing purposes. You can read more about the specific metrics here and here.

I bet you’re naturally wondering what the best and worst portfolios are on the chart. Let me make them easier to spot.

See that sad, ugly carrot with a low baseline return and a sky-high ulcer index? That’s large cap blend with no other fund at all. That’s right — the standard S&P500 was the worst option of them all. What do you want to guess is the beautiful carrot at the top? What exotic mix of assets did best? It’s actually not a mix of assets at all. It’s just small cap value by itself! The most diversified factor portfolio topped the list.

Of course, this could just be an artifact of some sort of special circumstances with US stocks. So as a sanity check, let’s do the same exercise out of sample with World Ex-US stocks.

Believe it or not, the two carrots in this case are the exact same as before with SCV leading the pack and LCB trailing everything else. Looking at every investing timeframe both inside and outside the United States, literally any combination of small, mid, or value funds boosted the risk-adjusted returns of a traditional large cap portfolio. And a pure small cap value fund came out on top in each case.

While we’re here, allow me to point out one little detail that even factor fans might find surprising. The trend in both charts is rather strong showing that diversifying factors not only increased baseline returns but also lowered the ulcer index. While academics may attribute the higher performance of various individual factors in terms of market compensation for increased risk, once you start looking at timeframe-independent downsides you start to realize that diversifying factors can actually decrease the pain of holding a portfolio. When you know the many factors that go into growing that prize-winning carrot, doing more than one increases your odds of a favorable outcome and decreases your odds of a particularly bad crop.

So when I look at data like that, I can completely understand why people spend so much time and effort researching how to grow the perfect carrot. Even if they’re going through a cold spell now, the downside for factor-diversified portfolios still looks pretty darned appealing compared to the downside for portfolios that rely primarily on large cap blend.

Could the markets have fundamentally changed in a way that permanently negates certain factors and renders the data obsolete? Sure — it’s possible. But I understand when farmers take their chances with the carrot-growing factors that have worked so well over the years. Maybe a certain pest has long moved on and the associated pesticide isn’t as useful as it once was, but I imagine it also doesn’t hurt.

I mean seriously, those are some tremendous looking carrots grown using all the best cutting-edge agricultural science.

So as a student of investing, I understand the research behind factor investing and I respect the hard work that goes into compiling the numbers and putting them into practice.  I even have some small cap value in my own portfolio, but maybe not for the same reason that the hardcore factor proponents might think.  Don’t get me wrong – I like carrots. I appreciate their health benefits and I do enjoy a great one.  But fixating on farming science has a way of missing the big picture.

You see, rather than obsess over stocking a pantry full of perfect carrots I prefer to spend my time figuring out what combination of ingredients work best with those carrots to make a great carrot cake.

In this case, those other ingredients are important things like bonds, cash, and real assets like gold. For example, let’s go back to the previous chart with different combinations of nothing but US stock indices. What happens when we start to add more types of assets? Pay close attention to the cloud of options.

While you’ll notice that SCV still features prominently in many top portfolios, it’s just one important ingredient in the recipe. Rather than simply looking for an edge in returns, good portfolio management is also about pushing that entire cloud to the left towards an investing experience that you’ll actually enjoy and will be able to stick with long-term. Carrots are fine, and if you’re really into them good for you. But to me that cake looks downright delicious.

Beyond the much more desirable dining experience compared to munching on a plate of raw carrots, the nice thing about focusing on the recipe is that it helps put the individual ingredients in proper perspective. Just like how small cap value may be going through a slump right now, maybe it’s not really carrot season. If all you eat is carrots, then the mediocre product compared to tastier options may indeed be cause for concern. But are you really going to notice a sub-par carrot in a well-made carrot cake? I seriously doubt it. And it’s certainly not worth losing sleep over or taking to Twitter to argue on either side of the ongoing carrot debate. A good cook will trump an expert farmer at the tasting competition any day.

So be smart about it. Learn enough about factors to know how to effectively put them to productive use, but don’t place them on a pedestal or let them distract you from what is most important. Factor diversification is great, but true asset diversification is how the most desirable portfolios are made.

Did this satisfy your portfolio sweet tooth?