Financial thinkers have discovered multiple “factors” that contribute to stock returns over the long run. This line of financial thought 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 which a stock’s systematic or market risk (also known as “Beta”) is the main factor determining the stock’s return.
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 correlate historically with higher returns for stock portfolios. 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 (stocks that have posted positive returns over the preceding 3 to 12 months tend to continue to produce positive returns), that is also correlated with higher-than-average returns. Several researchers from institutions such as the University of Chicago, Stanford, Yale, and other top schools have confirmed and cited this research, and these factor models are widely accepted among financial thinkers.
At Armbruster Capital, we apply this academic research, and invest in funds with exposure to these factors. We buy funds that invest in small companies, as well as funds that hold value and momentum stocks. These size, value, and momentum tilts create an index strategy that has historically outperformed the S&P 500 without incurring significantly more volatility.