Academic Research, Applied to Your Portfolio
Factor investing isn’t a new idea. It’s the result of decades of rigorous financial research and has a real track record of enhancing long-term returns, particularly when the broader stock market underperforms.
What is factor investing?
We use index funds with specific factor characteristics to tilt the portfolio toward market segments that have historically delivered long-term returns in excess of the overall stock market.
This line of thinking began with Professor Harry Markowitz’s seminal paper on Modern Portfolio Theory in the 1950s. Markowitz outlined the importance of diversification and the risk-return tradeoffs within a portfolio. His work was the basis for the development of the Capital Asset Pricing Model (CAPM). In the CAPM framework, a stock’s systematic or market risk (also known as “Beta”) is the primary factor determining its return.
The factors we rely on — and why they work
Professors Eugene Fama and Ken French expanded on the CAPM with their “three-factor model.” In addition to market risk, Fama and French discovered that size (small companies tend to outperform large companies) and value (companies with low valuations tend to outperform those with high valuations) factors historically have generated higher returns than the overall stock market. The three-factor model follows logically from Markowitz, since small companies and value stocks are inherently riskier, and therefore provide a higher expected return.
Researchers Narasimhan Jegadeesh and Sheridan Titman discovered a fourth factor, momentum, showing that stocks with positive returns over the preceding 3 to 12 months tend to continue producing positive returns. This has been confirmed by researchers at the University of Chicago, Stanford, Yale, and other leading institutions, and is widely accepted among academic researchers.
Over time, other factors have also become widely accepted, and we try to capture their long-run expected excess returns. We use a combination of value, momentum, quality, and low volatility to tilt portfolios toward these historically higher-returning market segments without taking on undue risk.
When factor investing matters most
Historical evidence suggests factor investing has been particularly strong during periods of weak overall market returns, which is exactly when investors need diversification and excess returns the most. A portfolio tilted toward value and quality may hold up materially better during a prolonged period of flat or declining equity markets than one that simply mirrors a cap-weighted index.
This isn’t a guarantee. Factors can go through extended periods of underperformance. For example, value had a difficult decade in the 1990s before rebounding sharply in the decade of the 2000s. But for investors with genuine long-term horizons and the discipline to stay the course, the long-run case for factor investing is compelling.
How we implement factor exposure
We use ETFs to capture factor exposure, specifically, funds that are rules-based, transparent, and cost-effective. This is not the same as buying an expensive active manager who claims to do something similar. Factor ETFs give clients direct, quantifiable exposure to the characteristics we’re targeting, at a fraction of the cost of traditional active management.
We research the available factor ETF universe carefully, evaluating not just the factor claims but also portfolio construction, how the factor is defined, how frequently it’s rebalanced, and how the fund handles turnover and tax efficiency. The details matter, and we do the work to get them right.
Want to understand how factor tilts might improve your portfolio's long-term outcomes?
Let's talk.
Frequently Asked Questions
Is factor investing the same as smart beta?
These terms are often used interchangeably, but they aren’t technically the same. Smart beta generally refers to rules-based ETF products that tilt toward one or more factors, which is essentially how we implement factor investing. However, true factor investing pairs long/short trading to isolate the true factor premium.
How is this different from just buying a value fund?
A single-factor value fund provides one tilt. Our approach combines multiple factors: value, momentum, quality, and low volatility because they have historically been only partially correlated. Combining them can temper the volatility in performance that comes with any single factor while preserving the long-run return advantage.
Do factors always outperform the market?
No strategy “works” all the time. Factor premiums are long-run phenomena. There will be extended periods, sometimes lasting years, where a factor underperforms a simple cap-weighted index. The evidence for the long-run premium is strong, but it requires patience and discipline.
Disclaimer: Investing in securities involves a risk of loss. Past performance is never a guarantee of future returns.