digest
Short Summary
Main recommendation: Most DIY investors are better off focusing on simplicity rather than pursuing factor investing, at least for now, because usable factor products at reasonable cost are largely unavailable to them. Factor investing (also called smart beta) structures portfolios around quantitative characteristics shared by securities, such as size, value, momentum, and profitability, to seek market-beating returns without stock picking or market timing.
Key Points
- Factors are quantitative characteristics shared across a set of securities, and factor models now explain over 95% of return differences between diversified portfolios, which undercuts the assumption that active managers' outperformance is due to skill.
- Justin Bender's 2015 analysis found that most actively managed funds recommended by Rob Carrick beat the market mainly by holding more small cap and value stocks than their benchmarks, which an index investor can replicate at a fraction of the cost.
- Factor research began with Fama and French's 1992 paper, with momentum added by Mark Carhart in 1997 and profitability by Robert Novy-Marx in 2012; the explanation for small and value premiums is that these stocks are riskier, while momentum lacks a sensible risk explanation.
- Campbell Harvey, Yan Liu, and Heqing Zhu have identified over 300 factors in academic literature, but many turn out to be repackagings of established factors, so investors should be selective.
- A factor should pass a "sniff test": persistent over time, pervasive across countries, regions, and sectors, robust to alternative definitions, investable at reasonable cost, and sensible in explanation.
Details Worth Noting
- Concrete instructions: Use the sniff test before pursuing any factor: check that it is persistent across time, pervasive across countries, regions, and sectors, robust when its definition is slightly changed, investable at reasonable cost, and has a sensible explanation. Avoid high-turnover factors like momentum if you cannot implement them cost-effectively. For DIY investors, the speaker's stated approach is to prioritize simplicity over pursuing factors, since juggling many funds leads to costly mistakes.
- The speaker names Dimensional Fund Advisors as a firm that implements factors well, noting that its products are accessible only through specific firms such as PWL Capital, not directly.
- The Canadian Couch Potato model portfolios pursued size and value factors but were changed in 2015 to ignore factors completely, following the reasoning that DIYers often make costly mistakes juggling too many funds.
- The speaker notes a lack of ETFs, especially in Canada, that effectively capture well-researched factors at a reasonable cost.
- Eugene Fama was awarded the 2013 Nobel Memorial Prize in Economic Sciences for his asset pricing work.
Bottom Line
Factor investing has solid research behind it, but for most DIY investors in Canada the practical barriers of cost, access, and complexity outweigh its benefits, so a simpler portfolio is the more sensible starting point.
