Note: Like the quarterly review, this will be a reoccurring series here on the blog. The catch is that it will only happen once a year. Like most investing rules, less seems to be more, and when looking at factors, even once a year is probably too often. So, this yearly exercise is used to see where we have been and to frame future expectations…nothing else.
As a quick refresher, “Factors” are simply characteristics that stocks can exhibit. For example, based on the market cap of a company (This is simply a companies stock price multiplied by the companies shares outstanding), aka Size, it can be described as a large company or a small company. Research going back to the 1920s has shown that over long periods of time, stocks that exhibit the certain characteristics described below, can potentially provide higher returns than just what the overall market provides. The best introduction I have found to this topic for beginners is Larry Swedroe’s book: Your Complete Guide to Factor-Based Investing.
- Beta refers to the total stock market weighted by the market-cap of all companies.
- Size refers to small stocks versus big stocks (i.e. When the “Size” premium is positive in a given year, small stocks gain more than large stocks).
- Value refers to inexpensive stocks versus expensive stocks (i.e. Stocks are measured by their price to their book value or earnings and when the “Value” premium is positive in a given year, inexpensive stocks gain more than expensive stocks).
- Momentum refers to stocks that have recently done well versus stocks that have recently done poorly (i.e. Stocks are measured by how much they have returned over the last 11 months and when the “Momentum” premium is positive in a given year, stocks that have recently gone up the most, continue to go up).
More importantly than possible increased performance though is that these so-called “Factors” typically go up and down at different times. This affords us the ability to diversify our equity holdings. This is important as I am a firm believer that I cannot predict the future and because of that, I find it prudent to gain exposure to the factors that I believe in. So, instead of just investing in the Total US Stock Market (aka Beta), I believe that by purposely gaining exposure to Size, Value & Momentum in addition to Beta, I am giving myself a better chance at reaching my financial goals. Even if these “factors” show no premium over the next 5 decades, as long as they continue to go up and down at different times, it will help our portfolios. Now, onto the annual review…
Despite all of the reasons why equity markets “should have” collapsed over the last year, it turned out to be quite a strong year. The first table shown is the annual factor returns for the years 2015 and 2016. As we can see, almost every factor had a large positive turn around from 2015 to 2016. The only factor that had a large swing in the negative direction was momentum.
Now the charts above probably don’t mean much to most people (Except to select investment nerds like myself), so lets see how these factors actually produced in the real world. The world where we get a funds return value and not some database’s return. The funds we will use as our proxies are:
- VTI is our proxy for “Beta”
- VB is our proxy for “Size”
- FNDX and FNDA are our proxies for “Value” (FNDX is Large Cap Value and FNDA is Small Cap Value)
- MTUM is our proxy for “Momentum”
- MTUM 30 / FNDA 70 is our proxy for a possible “Multi-Factor Portfolio” (It has positive exposure to Beta, Size, Value and Momentum)
As we can see below, in 2015 all of our funds struggled with the exception of MTUM. By looking at the annual factor premiums in the first table above, we could have guessed that the market was flat (Beta was 0.07), and any exposure to Size or Value would be a negative, while any exposure to Momentum would have been positive. Turns out, that is exactly what it looked like. VTI was flat, our proxies for size and value were negative and our proxy for momentum was positive.
In 2016, the tables turned dramatically. Based on the 2016 factor premiums in the first chart, we would guess that the market was up double-digits, Size and Value were positive while Momentum was negative. Right again. Our proxy for Beta was up double-digits, any exposure to Size and Value was a positive, while any exposure to Momentum was a negative.
As one would expect, our proxy for a Multi-Factor Portfolio was not the worst or best in either year…ahhhh the joys (I am on this team) and/or frustrations of diversification (It depends on your outlook).
So, where do we go from here? My guess is as good as yours. I think value will continue to have a positive premium over the next couple years while momentum and size bounce around, but that is just a guess. Regardless of what happens, my portfolio will not change as I already have exposure to the factors I believe in and hopefully you do too.
P.S. If you simply invest in a Total Stock Market Fund, you can still be a part of the factor party. Just tell people you only believe in the Beta factor =)
Have some fun out there!