A Closer Look at Factor Investing
For those of us who are evidence-based investment managers and subscribe to the tenets of Modern Portfolio Theory, there are specific considerations we use in designing client portfolios. We believe that markets are efficient to the degree that makes stock picking unlikely to produce excess return, and we see no evidence that market timing is a viable strategy. We consider diversification and the weighting of certain securities in the portfolio. By overweighting certain groups of securities, we increase the portfolio's exposure to "factors".
These factors are variables that explain differences in returns of certain groups of securities. To be viable, a factor must demonstrate persistence over long time periods and pervasiveness across countries, regions, sectors and asset classes. They must also be intuitive or explainable by financial or behavioral economics, and investable — able to be captured considering implementation issues. There are many factors that have been identified, but few that pass all of the viability tests. For our purposes, we will focus on the four arguably most important factors in equity investing — value, size, profitability and momentum.
Lower Price Relative to Book Value
The first of the factors in the Fama-French three-factor model that we will examine is value. A value stock tends to trade at a lower price relative to its book value than a growth stock. There are many ways to measure the relative value of a company’s stock, the most common among academics being the Book-to-Market ratio, or BtM.
Value investing is well-known and has been studied extensively. Perhaps the best-known proponents are Benjamin Graham and Warren Buffett. Value is one of the factors identified by Eugene Fama and Ken French in their famous “The Cross-Section of Expected Stock Returns” paper, published in 1992 and later incorporated into the Fama-French three-factor model.
Value is persistent. In the US, value stocks outperformed growth stocks by an annualized 3.59% from 1927 to 20161 and in 95% of 907 overlapping 15-year periods2. The value factor is also pervasive. In developed international markets, value stocks outperformed growth stocks by an annualized 5.34% from 1975 to 20163. The same is true for emerging markets, where value outperformed by an annualized 4.07% from 1989 to 20164.
The value premium can be explained by asymmetric risk. According to a 2005 study by Lu Zhang, value stocks are much riskier than growth stocks during bad economic times and only moderately less risky during favorable time periods. In addition, there are behavioral explanations, notably the mispricing of value stocks due to optimism, anchoring and confirmation biases.
The value premium in investable. Over long and statistically significant time periods, value funds have outperformed growth funds around the world and funds with stronger exposure to the value premium have even outperformed value indices.
Clearly, the value premium meets all of the criteria for inclusion in client portfolios. Our preferred method of implementing value exposure in client portfolios is through the use of value funds managed by Dimensional Fund Advisors (DFA). We prefer DFA’s value funds due to their track record of strong and consistent value exposure, low expense ratios and tax efficiency.
- Fama-French US Value Index minus Fama-French US Growth Index.
- Value is Fama-French US Value Research Index. Growth is Fama-French US Growth Research Index.
- Fama-French International Value Index minus Fama-French International Growth Index.
- Fama-French Emerging Markets Value Index minus Fama-French Emerging Markets Growth Index.