Factor Investing - Which Factor Outperforms The Market Best?

a very simple but successful approach to investing is to buy the market we buy a single fund which tracks global equity say and over the long term that performs very well and usually you pay low fees for that kind of approach but it's just human nature that we want to do better than that we want to beat the market so we can either pay an active manager to do that usually the fees are high and 80 of the time they fail or we can go for factor funds like value or growth or momentum and over the long term these have been shown to beat the market so in this video we're going to look at some of those strategies both recently and over the long term to see which factor funds beat the market best so let's look at factor funds in a bit more detail so let's start off by looking at some of those factors in order to understand factors it's important to understand beta now beneath me the x-axis is the daily return on the s p 500 and the dots you can see above me are the daily returns of mgm results international those are in red and in blue we've got campbell's soup so what this graph is showing you is if the s p moves up by one percent how much do those two stocks move up typically notice how the slope of mgm resorts is much higher than it is for campbell's soup that's because mgm is a high beta stock when the s p moves up or down one percent then mgm will move up or down by 1.7 percent so it tends to respond to market news more than the s p in contrast campbell's soup is a kind of boring stock which actually responds less than the s p so the beta of campbell's soup is only 0.43 so that usually when the s p moves up one percent campbell's soup will only move up 0.4 percent and if the s p goes down one percent campbell's soup only goes down point four percent so really important factor in knowing the returns of a stock is the stocks beta things like leverage can increase beta but it also increases the business risk for a company so a prime driver of long-term return for a stock is going to be its beta but the pivotal research in factory investing which really kicked off the entire field was that once you adjust for beta certain types of stocks actually outperform more than you'd expect so for example small companies tend to perform much better than you'd expect once you adjust for their beta and what eugene farmer and kenneth french showed in 1992 was that two factors can pretty much explain cross-sectional returns in other words which stocks outperform and those two factors were the size of the company its market capitalization such that small stocks outperformed and the other factor was value cheaper stocks tended to outperform more expensive stocks over the long term of course many other factors have now been discovered and now that we understand the theory let's look at the performance of some of those factor funds so here they are the performance of 10 factors over the last eight years and that's restricted by the period of time for which i have complete data for these funds now what's really clear is that over that period three factors really outperform and that's growth so that's stocks which tend to grow their earnings aggressively and in particular large cap growth stocks and these would be the fang stocks which have done very well recently so facebook apple microsoft google for example but also momentum because that simply buys stocks which are trending upwards it doesn't know anything about the stocks it simply knows that they're doing well and that strategy although it seems very simple performs very well historically and if we look at the bottom of the table it's value which is underperformed even though pharma and french show that over the long term it's performed very well now remember high dividend yield is another version of value because if dividend yield is high that means that the stock price is low relative to the dividends paid so that is a measure of value and in terms of capital gain that's been the worst performing strategy over the last eight years so if we look at the value of a hundred dollars invested in those strategies at the beginning of this period in 2013 you can see how the returns look over that period i've highlighted the s p here in black to see which of those strategies outperformed and which ones underperformed and what that highlights is that all of the best performers are growth and momentum here at the top and the worst performers are the value funds here at the bottom it's always a good idea to balance risk and return and this is a risk return plot so on the bottom axis here we've got risk with high risk on the right low risk on the left and low returns here at the bottom of the graph and high returns here at the top now as we saw before the growth etfs are the ones which perform the best and what's great about that is that they've done so with a volatility which is roughly equal to that of the s p 500 now that sounds fantastic because you're getting higher returns for the same amount of risk as measured by volatility whereas if you go for small caps or small cap growth which is what you get with ishares russell 2000 that comes with a much higher volatility but over this period it certainly hasn't come with a higher return and in fact the worst of both worlds has been small cap value which has had high risk but also very low return less in fact than the s p and value investors at the moment must be in complete despair if we compare just two of those factors growth and value over this period since 2004 you can see that value isn't just losing it's losing by a massive amount and that's been the case for several years so in the next graph we'll look at the daily outperformance of value versus growth which is the returns you'd get if you go long value and short growth and this is what it looks like there was a period about performance initially between 2004 and about 2006 but pretty much ever since 2006 value has been underperforming growth the rate of underperformance has slowed down recently after the pandemic but it still hasn't recovered now if we look back over the long term and here i'm using pharma and french's data which goes all the way back to 1926 you can see that values outperformed fairly consistently over that very long period of time so this period of value underperformance which we've had recently is uncharacteristic but what i think makes value a very difficult proposition for investors certainly at the moment is the periods of time for which it's underperformed these strategies really only work if you buy them and hold them for long periods of time but what you can see in this table beneath me are the periods for which values underperformed growth now the most recent period is getting on for 15 years but you can see there have been other periods fairly extended periods when it underperformed in the past such as between 1937 and 1943 between 27 and 32 and between 88 and 93. so i think there are too many cognitive biases that would stop investors successfully buying value it would take nerves of steel to hold on to a strategy when it's underperforming for a period of five years so while the research shows that this strategy works well i think our cognitive biases make it impractical if you're enjoying this video then why not consider supporting us right here on youtube if you do that not only will he be helping us make more videos but also your questions will be answered as a priority during our live q a sessions they happen every other thursday to learn more about that click on the link in the description or on the join button under this video i think any practical approach to factor investing has to be one which avoids ulcers now fortunately there is a risk measure called the ulcer index which measures the amount of grief you're going to suffer based on drawdowns from the previous peak now this is always anchored based on the previous all-time high of your investment and that also tends to be more in line with the way we think about risk so the further you fall from the previous all-time high and the longer it takes to get back to that all-time high the greater the ulcer index so what we can see in this panel is how far we are beneath the previous all-time high and you can see that for the momentum index it's bumping along at its all-time high fairly consistently since 2004. there were some periods when it fell from that all-time high such as during the pandemic when it briefly fell by more than 35 percent but it very rapidly moved back to a new all-time high so this pattern of brief shallow drawdowns means a low ulcer index if we compare that with small cap value you can see a very different pattern there was a huge drawdown of more than 60 percent in 2007 and it took a very long time several years to get back to the next all-time high so this pattern of long deep drawdowns is one which gives a high ulcer index which is something we want to avoid so if we rank our factor funds according to this ulcer index with lots of ulcers at the top and very few ulcers down at the bottom you can see that factors like value and small caps tend to have lots of worry associated with them whereas growth minimum volatility and momentum tend to have a lower ulcer index but we also need to consider the returns on those strategies so here's our risk return plot but now on the x-axis we've got the ulcer index rather than volatility and certainly during this period you can see that growth and momentum are the factors which give us a good return combined with a low ulcer index but we do have to be careful during this period of comparison remember we had very strong equity returns how about if we look further back in time msci has a momentum index which goes back to before 1980 and what's really remarkable is that the period during which we did our previous analysis is one where the ulcer index would have looked very good for momentum that's because markets were essentially just trending upwards during that entire period the time when momentum has these big drawdowns is when a trend reverses and that's exactly what happened in 2000 when the dot-com bubble burst all of those tech stocks which had done very well suddenly started to have very poor returns and momentum didn't manage to turn around quickly enough and it suffered a big drawdown and then it happened again in 2007 with the global financial crisis as momentum reversed so for momentum the dot-com reversal took almost six years to recover from and then the global financial crisis bubble took a further five years to recover from over this 40-year period those were the worst two periods in terms of recovery time but still this shows the importance of having long-term data when we're comparing strategies and if we look at msci's other factor indices over this period since 1988 three of them really stand out momentum is the one with the highest risk but it also has a very good return of almost 13 annually over this period if we look at quality it has less ulcers associated with it but it also has lower return of about 11 per year and if we look at a us equal weighted index which has a tilt towards small caps that also has a good return which is slightly higher than the broad u.s market but it has considerably less ulcers associated with it but what's really notable is that growth which has performed incredibly well over the last decade has not had such a good run over the long term it has the highest ulcer index of all the strategies and it certainly doesn't have the best return what's also interesting is that low volatility and value and high dividend yield which is another form of value all performed very poorly relative to the us market and relative to those other factors so based on the last 40 years of data it seems like those two simple strategies momentum you buy rising stocks and quality where you go for stocks with good return on equity steadily rising earnings per share but also not too much leverage do very well but also they're more palatable in terms of risk that we can stomach so i think those are the most useful strategies if you are going to think about factor investing now remember you can help us by clicking on subscribe but also liking this video and as always thank you for listening

Channel: PensionCraft

Views: 36,192

Keywords: factor investing, factor investing explained, smart beta investing, best factor etfs, best factor funds, best smart beta funds, what is factor investing, investing, factor funds, beat the market, beat the market strategy, best smart beta etfs, best smart beta etfs 2021, investment, smart beta, smart beta funds, smart beta strategy, stock market, Pensioncraft, Pension craft, factor based investing

Id: wA3EznEzDD8

Length: 13min 8sec (788 seconds)

Published: Sat Aug 28 2021