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Dave Gardner
Dave Gardner

If you’re an engaged investor, you’ve probably noticed the recent flood of factor-based investments.

Factor investing started out as a relatively obscure set of strategies largely used by professional managers. Now most mutual fund and ETF companies offer factor funds including low-cost giants Vanguard and Blackrock. Now that most of us can access factor investing, does that mean you should?

Dave Gardner

To put it plainly, factors are certain attributes of a given investment that have performance characteristics that seem to persist over time. The idea is that by emphasizing certain factors when putting together a portfolio, the investor will end up with higher returns.

I’ve been beating around the factor bush a bit, so let’s explore the most common one. The first and most important factor is stock market exposure. If you have been putting money in stock funds through your retirement plan at work, by the literal definition you are a factor investor.

According to the Fama-French data, since 1927 the U.S. market has outperformed a risk-free return by 6.5 percent a year. Over an investing lifetime, that extra return can make the difference between living prosperously in retirement and scrimping.

As any stock investor knows, the additional return has not come for free. You must accept additional volatility when you hold U.S. stocks versus Treasury bills. All you needed was the 35 percent decline in the S&P 500 earlier this year to remind you.

The second factor is the return of small company stocks versus large company stocks. For our purposes, a small company stock has a market capitalization in the lowest 10 percent of publicly traded stocks. Using that same data set, U.S. small company stocks performed 2.2 percent better per year since 1927 than larger ones. Again, this additional return came at a cost, as small company stocks tend be more volatile.

Next is the third factor that categorizes a stock as value or growth. While there are many definitions of a value stock, we’ll focus on the book value of a company — the worth of a company’s assets after debts are paid. Value stocks have relatively high book values, while growth stocks have relatively low ones.

Value stocks have outperformed growth stocks by 3.5 percent annually since 1927. The last decade has seen emphasis on additional factors, namely profitability, momentum, and investment. Profitability is defined as gross profits of a company versus its assets. Profitable companies since 1964 have appreciated 2.8 percent more than companies with low-operating profitability, according to Fama-French data.

The momentum factor refers to the tendency of stocks that have performed well in the last 12 months to continue to do so.

Finally, the investment factor refers to companies that invest comparatively less in assets and that tend to appreciate more than high-investment companies.

While we have mentioned six factors here, there are many others in the factor soup. So how should you use them to build a portfolio for you?

First, know that there’s nothing wrong with investing in low-cost mutual funds and ETFs that simply capture the returns of the entire market. The issue with factor investing is that despite higher average annual returns, there can be decades where a given factor won’t help you at all.

Small company stocks have been soundly beaten by large companies over the last decade. Growth stocks have also performed better than value stocks over the same period. There are even long periods when bonds outperform stocks.

To be an intelligent factor investor, you need to be dedicated to emphasizing factors over your investing life. If you are tempted to jump ship after a few years of underperformance, like most investors you may be better served with a straightforward indexed portfolio.

David Gardner is a certified financial planner practicing in Boulder County. The opinions expressed by the author are his own and are not intended to serve as specific financial, accounting or tax advice.

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