Understanding Factor Investing1 – Every portfolio reflects factor choices, whether investors realize it or not.
Marcus Schafer (00:17)
This episode 26 of Greenstream where logic meets life and investing. This is Pat Collins and Marcus Schafer at Greenspring Advisors. Today, the conversation is going to be about how every investor is a factor investor. Last episode, episode 25, kind of the whole conversation was about every investor is active. In this conversation, every investor is a factor investor. So Pat, I was hoping we could get into what exactly is
a factor investor and why does it matter?
Pat Collins (00:49)
You know, our last episode being on index investing, I think it’s, this is a good kind of follow-up to that index investing obviously is trying to replicate an index. And we at Greenspring believe there’s ways that you can try to do a little bit better than an index. We talked about that in the last episode and some of the structural parts of index investing and trading and taxes and things like that. we’re going to get into a little bit more of.
some specific items where we think that investors can try to outperform an index in a way that’s rooted in data and evidence and academia, but it’s going to start to veer a little bit further away from index investing when we get into factors. So I think when we say factor investing, basically what we’re talking about is deviating from the index in some way with either a group of stocks or a
a way of kind of grouping investments in a different way than the index does. The index typically will group them just based on their market cap weight. Largest companies have the highest percentage weighting in the index. We’re saying that there may be some evidence that we’re going to explore in this podcast to look at stocks and or bonds in a different way so that if we group them a little bit differently, not just based on their size, that we may get higher returns.
over time and we’ve got a lot of data and evidence to explain that. So think that’s going to be the gist of the episode.
What Is Factor Investing and What It Isn’t1, 2, 3 – Factor investing means intentionally deviating from market weights to target groups of investments with shared risk and return characteristics, not chasing outperforming stocks.
Marcus Schafer (02:17)
If go back to the index conversation, it was really about there is no perfect index and there’s no agreement on what that index is. So everybody you are deviating already. We were talking about, hey, U.S. total market, the deviations are five to 10 basis points, 0.05 to 0.1 % per year. Internationally, they’re bigger. As you go into sub-asset classes, they’re bigger. So when you’re already deviating, now is the question of, well, are you doing so to better your portfolio?
or not. And you kind of talked about performance, right? We want to do a little better. There’s kind of a few different lenses you can, you can do better through. One is increase expected returns. And the other is, can you think about adding diversification and factor investing kind of helps you do both of those things. At the start, I kind of mentioned, Hey, every investor is a factor investor. That’s because the biggest factor out there.
is that stocks have a higher expected return than bonds. And every single investor is kind of deciding, hey, how much money do I want to have in stocks? How much money am I comfortable having in cash? So by definition, every investor is already a factor investor. And now we’re going to peel that back. If you agree that stocks have a higher return than bonds, well, what other sources of expected return would you also agree on? And then how should you think about managing
the trade-offs between how much you want to believe in this, how far into this should you go? Last episode, you kind of talked about this mountaintop, right? And there’s kind of this peak of optimization. You don’t want to go too far because now you’re really getting into something that’s going to start adding costs and reducing likelihood of success. So what’s that right balance? Hopefully we can talk about that.
Pat Collins (04:07)
I think it’s kind of interesting to go back to look at the history of factor investing. It’s not, it’s not that old. ⁓ know, really where this started to come about is probably right around the time that computers became available because that allowed researchers to start looking at the stock market in a different way. So obviously you need to have data to look to see do groups of stocks perform differently than the broad market? Do they have higher expected returns?
And really the person there’s a professor from the university of Chicago called Gene Fama. won the Nobel prize. was on these concepts of expected returns in different areas of the market. And if you listen to him speak, was kind of interesting. He talks a little bit about some of his first trials and you know, some of the factors that he was looking for. I mean, this was kind of brand new. Nobody is like wide open space for researchers. And I think there was this thought that
maybe specific industries had higher returns, maybe that’s a way to group stocks, is pharmaceuticals have a higher return than industrial stocks or something like that. And what they found was there really was nothing reliable there. And what they next got into is kind of some of these factors that we’re gonna talk about. And there’s probably, I don’t know how many dozens or hundreds of factors there are out there that researchers keep trying to.
figure out, they all kind of have their roots in just a few that we’re going to talk about. Probably the easiest ones to invest in and hopefully exploit over time. But it is really interesting that this is not something that in the 1960s, people were focused on. It’s definitely a newer phenomenon because of data being readily available because of the advent of computers, being able to analyze that data. So this started in the seventies and eighties, basically maybe like, like sixties when really computers just started.
And it’s really been more and more kind of explored, I guess I’d say over the last couple of decades.
Why Factor Returns Are Expected, Not Promised – Factor premiums improve long-term odds, but they are uncertain, volatile, and can underperform the market for long stretches.
Marcus Schafer (06:07)
It’s been explored over the past few decades in a really, really big way because these are massive opportunities. Most of these factors, they kind of range in expected performance of potentially being able to increase your performance by two to 4%. And the way they do these factors is it’s kind of compared to a different group of security. So it’s not saying on an absolute level.
And some of these are marginal and incremental, but 2 % 4 % increase in expect return over something different in markets is a massive outcome. can kind of think about if you’re targeting 7 % per year, roughly, according to the rule of 72, it’s going to kind of double every two years. Well, if you’re 8 % expect return, it’s going to double every nine years. That one year difference
Essentially means after 30 years, you’ll have 25 % more money. So there is this massive advantage for people to seek out performances. This is why active managers, despite for all the evidence saying, Hey, you actually underperform after your fees, we still evaluate them and try and chase them because there is so much incentive out there. ⁓ And a lot of this research, by the way, Pat, there’s over 300 different claimed
Factors. A lot of the research is now around. Well, what’s real verse? What’s just in the past? So hopefully we’ll talk about what what do we think are some of the some of the real ones?
Pat Collins (07:47)
You
mentioned the incentives are so high to try to find these things that could give you just a slight edge on the overall broad market. So I think we have to be careful as investors because there are a lot of incentives. Obviously, if you find something that you think is a factor that leads to higher expected returns, you might attract a lot of assets to you that generates fees. Obviously, there’s where the incentives lie. So as investors, we should be looking at these factors very skeptically, I think.
to try to understand why should these factors exist? Why should, we’ll get into some of these, why should small companies have a higher return than large companies? To me, we can get into all the data, but to me, where it starts is the fundamental why question of is there a economic reason why this should exist? And which I think we’ll talk about. ⁓ But I do think that’s an important thing when you’re looking at any investment strategy, factors, something else, why should this persist?
in the future. And, you know, then, and then if you still think you have a good why, then looking at, okay, we looked at it in the U S for example, but does this actually occur internationally? Because why should it be any different if it really persists everywhere? It should be pretty robust. It should happen in a lot of different places. And that’s where some of these factors start to break down. When you get into, you know, more of the data behind it, you just have to be careful of data mining where people
go backwards and basically make the data fit a hypothesis that they have versus actually being real and should persist in the future for the reasons I talked about the why.
Marcus Schafer (09:24)
Yeah. Yeah. You were talking about, you know, academics and researchers are looking at this and one, I think we should have a lot more confidence around factor what’s real versus what’s not real compared to a traditional active management story, which is all narrative based, right? I think this is a good company. Well, why do you think that has that philosophy ever panned out? You can’t really even evaluate it.
And then when you go do evaluate it, like, Hey, let’s go look at all the narrative based stories and rationale behind investments. And 90 % of those types of strategies underperform. So it’s, you should have a little bit more confidence when you’re looking at factor investing, because people are applying this level of academic rigor to understand. One, we can look at what happened in the past and then two, should we expect it to happen in the future? And you mentioned, you know, one economic rationale.
to does it work outside of your data set, right? That’s if it works in the US and it’s a real economic rationale, it should work in Britain. And if it doesn’t, it’s probably not a real economic rationale. The last thing, you know, if you looked at the data up through 1970, and then you want to look after 1970, does it still happen, right? That tells you it’s a real driver
of performance as opposed to something that was just a decade long trend. And markets are way more volatile than we want to admit. A decade of market performance actually doesn’t tell us that much. Another thing that’s really helpful in evaluating these different factors, can you vary your measurement criteria a little bit and still get very similar results? So
Historically, smaller companies have outperformed larger companies. You can define small companies a bunch of different ways. And over time, they tend to have higher performance. You could look at market capitalization. You could look at how many companies there are in the US and just sort by that. That’s kind of a market cap based approach. You could look at number of employees. You could look at sales in absolute terms. There’s a bunch of different metrics and they kind of all come back to similar
Similar points.
And that robustness of the measurement factor is super, super important as well.
Why Stocks vs Bonds Is the Original Factor Bet1 – The most widely accepted factor is the market itself: stocks have higher expected returns than bonds, and every investor chooses their exposure.
Pat Collins (12:02)
You know, we’ve talked a little bit about maybe the most important factor, which is we call it the market factor, which is just we expect stocks to have a higher return than bonds. And if you believe that, obviously, then it’s not unreasonable to say, well, within stocks, are there stocks that have higher expected returns than other types of stocks? And that’s what we’re going to get into here. So I think the first one to come to is probably the most widely cited
I think it’s been around probably the longest outside of the market factor, which is the two factors of size and value. So maybe we can take a few minutes just to talk about what they are and more importantly, kind of coming back to the why. But we’ve been talking about small caps. So let’s start there. So we know we have about a hundred years of data in the U S good data in the U S to kind of segment stocks by their size, small cap and large cap.
And so we know to your point that it’s about two percentage points or so over the last hundred years of data of small companies having higher expected return or higher returns than large companies. So we can maybe talk about different time periods and whatnot, but I do think it’s important to say, well, why is that the case? Why should small companies outperform large, especially I think this day and age where we actually haven’t seen that happen very often over the last few years.
And in fact, you hear people say a lot now that the large companies have so much scale and so much size that they’re going to dominate and they’re going to basically push out all of these small companies because of AI or because of other factors that allows them to kind of reinvest. So I just like to start with this. And I think I’ve mentioned this on the podcast before, but I’ll mention it again. I like to start with this story. sometimes sell this to clients and it’s just more of a thought experiment to some degree.
And if you are thinking about investing, let’s say, and you had a hundred thousand dollars to invest, and I gave you two different choices. One choice is let’s just use Apple. Apple will represent a very large company. And then the other choice that you have is a startup company that your buddy has just started in some technology area. So these are your choices.
One is representing a very large company. One is kind of a, a, an example of a very, very small company. So if you have a hundred thousand dollars and you go to invest in those funds, into those stocks, and you’re looking at which one to choose, let’s say Apple comes to you and says, we’re going to offer you a 10 % return. We want your capital and we’re going to use it to help grow and expand our business. So you say, okay, 10 % returns. Good. Let’s say your friend who has a startup does the same thing says,
We really need your capital to invest and grow our company. We’ll offer you a 10 % return. I think after you think about it for maybe about 30 seconds, you would say, well, why would I invest in a startup that has a tremendous amount of risk? It could be gone in the next three months or six months compared to Apple that’s been around for a long time. And I think they’re probably going to continue to sell some iPhones. They’re probably going to be around for a while. If I’m going to get the same return in both
scenarios, I’m going to pick the more sure thing, the Apple kind of stock. The only way and investors know this, this is kind of what’s happening in the market. This is this economic rationale. The only way for this startup company to attract your capital is to offer higher expected returns than what the large cap companies offer. So you’re maybe your friend is the startup says, you know what? know Apple’s kind of guaranteeing a 10 % return or has a 10 % return associated with it.
knowing that maybe if we offer 20%, Marcus might be interested investing in this startup company. Now you might think about it. Now you might say, okay, it’s a lot more risky, but I have a higher expected return. And that’s really kind of what’s happened over time. You could kind of think about it as cost of capital for companies as when companies are riskier, they have to offer higher returns to attract capital. When they’re safer, they can offer lower returns to attract capital. And that’s why
There’s this discrepancy in returns. The last thing I would just say is investors looking at that should not be looking at this in a vacuum to say, well, if small caps have a higher return than large caps, and that’s been historically true, why would I not put all my money in small caps or maybe the majority of my money in small caps? And the other side of that is the risk factor. Those companies have higher risk. They’re more volatile. Most people have a harder time dealing with the ups and downs and
Quite honestly, they have a different kind of tracking error compared to the market. So a lot of people just don’t want to see, you know, if the S &P is up 10%, they don’t want to see their portfolio up too, because that’s just such a major difference than what the market looks like. So I’ll stop there, but that’s kind of one of the bigger, you know, the size factor. Hopefully that’s kind of an explanation of what it is and why it should persist.
Marcus Schafer (17:13)
All reason why people don’t want to put all their money in it is a reason why we would expect it to have better returns, right? Risk and return are related. It is always helpful to think about these one-on-one examples, but then you should know as an investor, hey, if you’re looking at a one-on-one example, we actually can’t tell you whether Apple or that single company is a better one. And one of the things that
the researchers are doing is they’re trying to say, well, what we really mean is let’s get a basket of 500 big companies and a basket of 2000 small companies. And then let’s tell the difference between those two. And that’s a way to understand, Hey, is the risk we’re taking this kind of gets back to things we talked about before. it compensated or uncompensated? And when you look at big baskets, a lot of big companies and a lot of small companies, you’re more certain, Hey, that’s a compensated risk.
If you look at one company versus another company, that’s a lot of uncompensated risk, but yeah, small companies have historically done better than large companies as big, baskets. And it makes sense to probably own a little bit more small companies over big companies.
Size and Value: Long-Term Evidence and Tradeoffs2, 3 – Smaller and cheaper companies have historically offered higher expected returns, but only for investors willing to tolerate discomfort and tracking error.
Pat Collins (18:29)
I agree. I think the next factor maybe we can touch on is the value factor. And this one is oftentimes misunderstood, I found, from investors. If you were to ask an investor, and maybe just even backing up, what the value factor is looking at is how cheap or expensive the price is relative to some metric that we can measure. So it could be earnings. It could be the book value of the company.
could be some other kind of metric that we use to determine what we think the value of the stock is. So high prices relative to, let’s say, just call it earnings, let’s say, because a lot of people will know what that is, ⁓ compared to stocks that have low prices relative to their earnings. And so we can sort all the stocks based on those factors and see which ones are priced very expensive and which ones are priced very cheap. Now, the market is
very smart. it is pricing things more expensive or more cheap because of a lot of different things that are probably happening with that company. Companies you expect to have very expensive prices are ones that have great prospects, ones that are expected to grow significantly over the next few years. It could be Nvidia or it could be, you know, stocks that are tied to AI in some way.
On the other hand, you have stocks that are really cheap relative to earnings. Those are the ones that probably don’t have great prospects. Maybe they’re even going through some turmoil at the company. you know, that could be companies like in 2008, a really great example would be financial services companies. Very, very, you know, tough situation for them. They were priced to a level where people weren’t sure if they were going to make it or not. So one of the things when you talk to investors that
You know, it’s interesting as you kind of go through this, if you ask them, would you rather have a company, would you rather own a company that is growing and expanding really, really quickly every year? Or would you rather own a company that is struggling? Maybe they’re going through some, some tough times. Everybody says, give me the growing and expanding company. What they don’t ask is what’s the price. That’s the really important factor. And that’s what this kind of factor looks at is.
relative to let’s say earnings or book value, what is the price of the stock? And what the data tells us over the past about a hundred years in the U.S. is that again, value companies, companies that are, you could call them having some trouble, cheap, relative to their earnings, have a higher expected return than companies that are growing and expanding quickly, but are expensive relative to say earnings. And so,
It is a tough one because everybody wants to invest in a thing that is just high flying and is going to do really well and try to pick what that thing is. It’s so important to look at the price as well. And the last point that I would make is similar to your last one, which is we need to make sure we’re not picking stocks based on this individual companies. can basically select whole baskets of companies that fit this criteria of being cheap relative to, you know, expensive. ⁓
Marcus Schafer (21:46)
of people when you ask them, how do you think you should invest? The comment is, well, we want to go buy great businesses. And that’s half of the challenge. And the real challenge is we want to go buy great businesses at a price that we as investors can get paid from. if everybody wants to buy great businesses, what’s that going to do to the great businesses? It’s going to shoot their price up.
And it’s going to lower their expected return. And it is this kind of counterintuitive at first blush, but it’s not necessarily great businesses that you want to have as an investor because those are going to be expensive. It doesn’t mean that those businesses are not great for us as citizens or to have in our country or just as people like they’re, hopefully they change the world and hopefully they keep being an amazing business.
But it does say, an investor, it might not be the expected return that we’re looking for. And I think to that point, it’s about balancing the price compared to what you expect to receive. ⁓ And if you expect to receive a lot, the price is going to be a lot. And so this is just a way to help filter what’s the difference between a good business and a good investment. the value factor, that one’s
been around since the early 90s. And we’ve gotten more insight into the value factor where we could start to compare things like profitability helps give us another really good lens to understand, hey, what’s that price you pay versus what you get? So value and profitability go really, really nice together.
Pat Collins (23:37)
probably
a good time in the podcast to talk a little bit about persistence of these premiums or factors over time. And I think a lot of times people will hear this and say, well, I’m convinced I should invest in small companies or value companies or some combination of the two. What you have to recognize is that there can go long, long periods of, investing in these, you know, areas of the market where you will underperform the broad market. That’s why it’s risk.
That’s why it’s called risk is that you may not experience what you thought you were going to experience when you purchased it. So expected returns may not meet, you know, kind of your expectations. And we’ve seen that over the last 10 years or so, what have done the best? It’s large companies that are expensive. Those are the companies that have done really, really well over the past 10 or so years. So those that are investing in these should have, I believe, kind of like a belief system that they
truly believe that these are long-term investments and we could go through a decade or two where they underperform. We do know, I equated, when I talk to clients a lot of times, I equate it to longevity to some degree. So if I’m thinking about my health, it really is helpful if I am eating really well, exercising every day. It doesn’t guarantee at all that I’m going to live to a hundred years old.
It really improves my odds that I’m going to, but there’s no guarantees. The same thing with investing. We can invest in small companies in these value factors. It improves our odds that we are going to do better than the broad market, but it is no guarantee at all. And that’s just something as investors we have to accept. We are improving our odds, but it is not black and white. It’s not a hundred percent. So they talk a lot about.
making good decisions and divorcing that from the outcome. To me, factor investing is one of those things that you have to say, I’m making a good decision. I know the odds are in my favor. I also know it may not work out, especially the shorter timeframe I’m looking at.
Marcus Schafer (25:44)
Look at stocks compared to bonds as an example. Almost all investors are in broad agreement. Stocks are going to have higher expected return than bonds over longer time periods. No, I don’t think that’s really disputed statement, but we all know that stocks are going to underperform bonds in short time periods. ⁓ Whether or not you could predict that, we don’t think there’s any evidence you could predict that, but
there is a difference between expected returns and realized returns. And I think that’s one of the biggest challenges for investors is the world in the past, that’s all expected in the future, it’s unexpected. So if you think about, gave the example, ⁓ kind of expensive companies in the U S have done really well over the past decade. Well, you really have to go back and think.
Was that expected at the time or was it unexpected? And I think a lot of this growth is kind of unexpected. And that’s, it’s actually great because these companies beat expectations and that’s the whole game. Relative to expectations, can you outperform or underperform? Expensive companies have really high expectations. That makes it very difficult to beat those expectations. Cheaper companies have lower expectations. It makes it easier to outform.
those lower expectations. And it’s just this balance between trying to find the right mix so you can be in something you’re comfortable with. We talked about the best financial plans, one you can stick with. you don’t want to be, factors are two-sided. There’s small and there’s big. You don’t want to be all small, but you probably don’t want to be all big. It’s about finding the balance between those two. It’s about growth versus value.
all be growth and no value, it’s gonna widen your range of outcomes over time. And that’s the opposite of what we wanna do as investors. We wanna get more certainty. Why do you want more certainty? Because then you can spend the money you’re saving.
Pat Collins (27:53)
It’s funny when we talk about factor investing, a lot of times I totally agree with you that the idea that I think everybody has it ingrained that stocks will outperform bonds over time. a kind of a generally accepted truth from most investors. So when we have periods like 2000 to 2009, we had a 10 year stretch where bonds underperformed stocks. Most people, well, know, obviously some people
Marcus Schafer (28:21)
out perform stocks.
Pat Collins (28:23)
Sorry, yes, bonds outperform stocks. I’m sorry, yes. So most people during that time still believed in stocks and state invested. There certainly were a few people that said, I can’t take this anymore. I’m getting out. But I see less of that kind of conviction when it comes to small companies, large companies, value companies, growth companies. It’s just an observation I’ve seen. Even though the data is pretty strong that these factors tend to outperform,
One of the things that we kind of see with at least clients anecdotally is they’re quick to abandon them if they’re not working very well for a few years. So I think if you kind of believe in the market factor that stocks and bonds, you know, stocks have a higher return than expected return than bonds, I would encourage you to look more into the factors as an investor to kind of really dig into this because there’s similar probabilities there, but you just have to be willing to accept.
periods like we went through the stock market in the 2000s and like we’re going through now, maybe with small companies versus large.
Marcus Schafer (29:29)
Yeah, I
When I make smoothies, I put a little bit of spinach because I don’t want to eat the spinach on the side. I don’t want to do a whole thing of spinach as an eater. That’s just very unappetizing to me as an investor, ⁓ standalone part of your portfolio, just being small companies. Probably not, not the way to go. It doesn’t mean spinach is bad for you. Spinach is good for you. It’s how to find a way to incorporate it into
your diet in a better way. So what do do? You put a little bit of spinach in your smoothie, blend it all up, just enough where you could see the green specks, but you can’t taste it. That’s how I think about investing. That’s another way to think about building your portfolios. You want to be, hey, how can I get some of the benefits without making it so noticeable? I can’t stick with it in shorter volatile time periods.
Momentum: Why Trends Exist4 – Momentum appears consistently in market data, but high turnover, costs, and behavioral challenges make it difficult to capture in practice.
Pat Collins (30:29)
I that. Love that analogy. Maybe moving on a bit. This is one of my most problematic factors. I struggle with this one, just quite honestly. The data’s there. It’s definitely evident. I’d love to hear your take on it coming from an asset management background, that a firm that recognizes it, tries to kind of use it to their advantage. It’s the factor of momentum, which is the idea that stocks that are trending upwards or their prices going up.
will tend to stay in that momentum. Kind of the momentum will continue them into rising prices and conversely stocks that are falling will tend to stay falling. When I think about all the reasons why that should be the case, I struggle with it because I have a harder time finding the economic kind of intuition behind it, but it definitely exists. We know that, that there’s some empirical evidence there. What are your thoughts on the momentum factor and then how do investors actually take advantage of it?
Marcus Schafer (31:25)
Yeah. So momentum is, as you said, companies that have, that recently have done well, tend to continue to do well. Companies that have recently done poorly, continue to do poorly. I think it’s sometimes difficult to rationalize from the efficient market perspective, which is, whatever the price we see, that’s the best approximate ⁓ true price. So if it’s not related to fundamentals, it doesn’t matter. ⁓ A lot of momentum is probably earnings.
moments, right? You’re talking about price momentum, just what’s the price of the company. But there’s also how our earnings changing and is that being incorporated? So it could be some earnings momentum. ⁓ The truth is nobody really exactly knows exactly what’s happening with momentum. It seems the magnitude seems to be decreasing over time, which might tell you that you shouldn’t count on it as much.
going forwards, but the truth is you kind of see it in happening in portfolios. So it’s just around how do you, how do you incorporate? Momentum makes your portfolio change a lot because companies that have done well, they’re not the same companies all the time, right? So you’re looking at changing your portfolio 100 to 300%, which means essentially every three months, every one month,
You have to completely rebalance your portfolio. That costs a lot of.
There’s a lot of costs associated with that. Even, you know, in this day of no transaction fee, there’s still a lot of implicit costs and those costs tends to eat away at the performance you can realize.
So, momentum’s there, explanations are starting to better come out. We’ve noticed it for like 30 years, and it’s only now that researchers are really starting to unpack exactly what’s driving it, some earnings momentum. Maybe there’s some industry effects at play, but it’s there. Don’t ignore it, but definitely don’t chase it, which is what most investors do is they chase.
Quality: Profitability, Balance Sheets, and Staying Power5 – More profitable companies tend to deliver better outcomes when controlling for size and valuation, helping refine factor exposure.
Pat Collins (33:44)
And maybe that’s a factor of it. Is there something behavioral going on there? You know, just in, least in the short term that when somebody sees something going up in price, they want to, they want to own it and, you know, it doesn’t last very long because there may be not as much fundamental factors kind of going into it. So it’s a little bit more of a short-term factor, but it is there in the data. I think we’ve, there’s some of the investments that we select for clients tries to incorporate momentum into their trading, meaning
You know, if they see a stock that is going up in price, they may be okay holding onto it for a little bit longer. And conversely, if they see a stock stock dropping, they may wait for that to bottom out a little bit longer before they add it to a portfolio. So there’s, there’s ways you can probably incorporate it. Not into your overall trading to say, I’m going to turn this thing over 300%, but more into just at the margins. am I rebalancing?
How am I adding things? How am I taking things out of a kind of a market based portfolio? So, the other, I guess, maybe the last factor that we have that we think is kind of really meaningful and pretty robust is profitability. And, you know, this is another one when I first heard it, I always thought to myself, shouldn’t price
Reflects the profits of a company if a company has high profits, then they’re probably going to have a high price and it’s just going to get reflected in the price and be arbitraged out for the most part. I think this is looking at a little bit differently. ⁓ and saying if we have two companies that we can hold constant, meaning the company is the same size, two companies have the same size and the same kind of value factor like relative to price relative, let’s say to earnings or book value.
If we have the exact same company, but one is much more profitable than the other, that company should have a higher expected return. ⁓ And so it’s kind of this, this one is interesting because it molds, kind of brings a few factors together to figure out how to implement is what I’ve found over time. But love to hear your thoughts on profitability, how investors should be thinking about it.
Marcus Schafer (35:50)
I think the way you described it is great. It’s about, your assets more productive or less productive on a relative basis? As investors, the number one thing that we care about is what is the cashflow coming to us in expectation?
Growth essentially says, hey, we think that there’s going to be a lot of cash flows coming to us, but those cash flows are far out into the future. And one of the reasons why we would be hesitant about that is the further you go out into the future, the more unlikely it is to realize that, right? That, hey, I could predict the next one year on expectation much better than I could predict what’s going to happen in 10 years. Value, you could predict those.
cash flows a little bit more. so profitability is just about trying to understand relative to your assets.
what one is going to produce more cash flows to you as a shareholder. And that’s, that’s what you’re looking for. So might be a little, it might be a little counterintuitive, but it’s profits coming to you. There, there might be some risks to those profits in the near term too, that is being factored in.
Pat Collins (37:05)
So we basically have touched on four factors. Let’s call it size, value, momentum, profitability. You mentioned there’s 300 known factors that are out there. So, you know, are there anything else that investors should be considering when they are making investment decisions from a factor standpoint? What are the other factors that we should be looking at or?
there’s most of this stuff noise that we want to be careful of kind of, you know, kind going all in on.
When More Factors Don’t Help – Beyond the core factors, many proposed premiums add complexity and cost without meaningfully improving diversification or returns.
Marcus Schafer (37:38)
you’re trying to do with factors is you’re trying to explain the most with the least. And so the more you add different variables, they’re more, they conflict with each other. So those first understandings of these factors, those were massive improvements in expect return. And now everything else is incremental improvements of expect return where there’s a lot more trade-offs. Meaning the more profitability you get, the less value you get. ⁓
Momentum is like that. That’s that’s trade-off. So all these other incremental things, they are great if you’re trying to get a PhD in finance, because you can say, Hey, I discovered this factor. But when real practitioners go to try to figure out how do I incorporate this? They figure out it most of the time, a lot of the stuff is just going to cost more money to pursue than it’s going to add in terms of benefits. So yeah, there’s, there’s 300.
But a lot of them, you can kind of distill back to the ones that, that we talked about. And the ones we talked about have some of those things we were referencing in the beginning, which is we believe that they are more enduring because they’re essentially how investors are valuing companies. They’re trying to understand what’s my future cashflow. And then that tells me dependent on risk, how much I should be willing to pay today. So there’s a lot of.
wonky wants I could name some some wonky wants if if you
Pat Collins (39:14)
It’s, it’s, I totally agree that you can kind of get down a rabbit hole with this stuff. And I think if you keep it at a high level, clearly just at the very highest level, figuring out your mix of stocks to bonds, which we consider like the number one factor is really important. And then once you get past that it’s okay. Inside the stock market, how much do I want to allocate towards small companies versus large value companies versus growth profit?
profitable companies. So there’s all these decisions that you have to make. And like you said, there’s trade-offs with it. comes, you know, I think risk is as a big trade-off. also think how different you can look than the market itself is a risk factor you have to consider as a behavioral risk factor of, I willing to stick with this because it is going to look different than the market. Some years I’m going to love that because it’s going to look different in a real positive way. And some years I’m going to hate it because it looks different in a real negative way.
The goal obviously over time is that the positives outweigh the negatives. And that’s where we get this kind of this extra premium that we’re talking about. But what are some of the what are some of the refrains we’re hearing from investors or from, you know, professionals around factor investing? What are some of the things that people are saying, you know, why you shouldn’t pursue it? I think it’s probably a good good idea to just kind of show the other side of it for, you know, for for investors.
Common Critiques of Factor Investing6 – Skepticism often stems from recent underperformance, volatility, and the discomfort of looking different from the market.
Marcus Schafer (40:40)
Why you shouldn’t pursue it. I think the number one question people have is, well, because it hasn’t happened in the past decade. I don’t believe it’s going to happen over the next decade, which is really a question about accepting volatility. Nobody tends to have that same question to the same degree about stocks for bonds. People have it.
And then you go and you look at their portfolio and it’s mostly mostly stocks. OK, so that’s more a theory that you’re not really willing to deviate. I think that’s one. Is. Hey, the volatility so high, maybe I don’t expect it in in the future.
Pat Collins (41:27)
The other part to that is people that are trying to, you sometimes you see this in the stock market, people will move their allocation around trying to, you know, out-guess the market to some degree to say, well, I’ll switch it back into, you know, 75 % stocks when things start to look better. And, you know, the stock market moves quickly. It’s very, very hard to time those things. I found factor investing maybe is even more so.
Maybe because we’re not as, it’s not as in your face as the market is. You turn on the TV and it’s right there with the markets doing day to day. But you know, a great example is just this year, small cap value is underperformed last year by a significant amount. And now just in the first 27 trading days of the year, I think it’s outperforming the market by something like six or 7 % just in a few, you know, just in a few weeks. So.
These, these premiums that you get in investing in, they just don’t happen uniformly. That’s the tough part is it’s not like you’re getting an extra 2 % per year. You may get all of the excess returns in a month or two over the course of like five years. And so that’s really the challenging part is you kind of have to be committed to it. You have to stay invested because these things happen very quickly. It’s I’ve never seen anybody be able to time this stuff. See, again, that’s why you have to kind of commit to it and say,
I think this is going to exist. don’t know when it’s going to show up, but I do believe it will show up. And therefore I just have to have the maintain the exposure to it.
Marcus Schafer (43:00)
This isn’t really ever a frame from factor investing, but this is, think, like one of the big useful things is a lot of times somebody will be saying, well, I’m in this fund and it’s done really well.
And I think that reason is because the manager has skill. And what factor investing is great at is saying, no, when you compare that fund to its peers, funds that capture similar values.
This is like large gap growth in the US recently, right? Like, Hey, I think this fund’s done really well. Well, first question is, has the asset class done well or has the fund done well? And what factor investing does is it helps us understand in a lot of these cases, the asset class has done well, not the fund. And there’s a way to go get that exposure in a cheaper way. You can go into an index targeting a similar asset class or
more of a factor-based strategy targeting a similar asset class. And I think that’s one way where you could look at this and say, well, what’s a way I could use this information? You could evaluate is your manager good or did they just happen to be in a good asset class? If they are a large gap growth manager, they’re going to do better. They will have done better than other types of asset classes. It does not infer that that manager had.
extra skill, they were just playing ⁓ in a good asset class.
Pat Collins (44:37)
It was interesting. was talking to somebody the other week and this exact thing came up. They were talking about how bad a fund that they were in performed. And my comment to them was actually that fund is one of the top performers in that asset class. was just a bad asset class the last few years. And that happens a lot on the other side too. Somebody looks at a fund that says, wow, this fund is really outperforming. That is the one thing that factor investing.
you know, from the academic side really allowed us to do is to explain performance in a lot of ways, to look at performance and break it down and say, this was not stock picking proudness, that got us to a great return. This was exposure to small cap and value and what their exposure was. So I think it’s a great point that if you don’t know, it’s probably worth a conversation with an advisor to say, my funds, if they’ve done well.
Is it because my funds had been great stock pickers or because they’ve just been in asset classes that have performed well over time? So it’s it’s a great, and it’s probably a great lead into this last part, which is how can investors incorporate these factors? So if you’ve listened to this podcast, you say, that’s interesting. I’m an index fund investor. Let’s just say, is there a way for me to start to incorporate these factors?
So maybe I could get a little bit higher expected return out of my investments. How would you, how would you approach that?
How Investors Actually Implement Factor Tilts – Practical implementation starts with understanding current exposures and making thoughtful, diversified adjustments over time.
Marcus Schafer (46:05)
first
thing you want to try to do is look at what you’re invested in relative to the total opportunity set and then understand, are you more concentrated than you think? And for a lot of US based investors that tends to will have tend to mean like you own a lot of S &P 500 type companies. Well, there are small companies out there. There’s international companies out there.
And by just stopping and saying what percent of the total universe am I owning? That’s a good check just to understand what are your implicit factor exposures. And really what you want to be thinking about there is, is there some amount of diversification I can get? And diversification is a good thing. So we did whole episodes on this. Let’s try to figure out how to get some diversification.
Pat Collins (47:02)
Really trying to understand where are you today is probably the first step. You know, if you think about if I’m investing in something, let’s just say I am fully market-based. I’d like to know that like, is my entire portfolio just weighted exactly how the market index is? And most likely the answer to that is no. So then where is it that I am overweight or underweight? And are those factors that have had or show persistent higher expected returns?
So we do tend to see that when prospective clients come in, we’ll look at their portfolios and maybe they’re really overweight in large gap or really overweight in growth. And we’ll talk to them about where higher expected returns come from. And, you know, that that’s, I think that’s a, important factor.
Marcus Schafer (47:48)
Another lens, we kind of focused on stocks for most of this, but stock versus bond is a big one. another way to think about that is, is all of your bonds and cash, because there’s factors on the bond side too, right? And if you’re willing to accept some amount of credit risk, if you’re willing to say, take your cash and put it in a high yield savings account or put it in a money market fund or put it in a treasury bill.
There’s some amount of increased expected return. There’s some amount of increased risk. ⁓ So just trying to think about how much diversification are you trying to achieve? And there’s a lot of different ways to go about that, but it probably starts with some sort of portfolio analysis just to make sure, how concentrated am I into one company, one country, one sector relative to the broad market?
Pat Collins (48:47)
Obviously there’s some, some incentives here and conflicts of interest, but I would say this is an area I’ve rarely seen into an individual investors have a really good handle on. There is some value in working with an advisor, even if it’s just solely to dig into the kind of pop the hood on your portfolio and get a really good sense. Usually you can’t, it’s hard to do that by hand, especially if you have mutual funds. We have, you we, you know, Greenspring has software.
that we use to evaluate this stuff. But you can go online and there’s tools there, you know, whether it’s Morningstar or whatnot, you can go online and try to find some portfolio analyzer type tools to determine, you know, where, where is my portfolio? How much do I have in large cap and small cap and growth and value and profitable companies versus unprofitable companies and whatnot. So I think it’s a great place to start. And if you find that you are overweight or concentrated in an area that you think has a lower
long-term expected return, that’s where you can start to think about making changes to portfolios, whether that’s just rebalancing or using new money to kind of move up in certain areas that you maybe are underway to.
Marcus Schafer (49:57)
And
we kind of started this with a reflection of.
Every investor is active, right? It’s just the degree even index is active and ⁓ the less kind of active decisions, the more total market, the more certain you should be. That’s a better thing. So always start with total market selections and then think about how willing you are to deviate and if you’re deviating for the right reasons. And then we kind of ventured into this conversation, which is, well,
If every investor is active, that kind of also means that every investor is a factor investor. So try and understand factor exposure might be beneficial or don’t play that game. Go index total market solutions. But if you own a portfolio that says small cap or small value or ⁓ growth, you’re a factor investor.
Closing: Better Questions, Not Better Predictions – Factor investing isn’t about forecasting winners, it’s about improving decision quality and long-term odds.
Pat Collins (50:56)
I would venture to guess that’s the vast majority of investors out there have some tilts towards some of these factors, whether it’s known or unknown. We’re probably saying, make sure you know it, make sure you understand where your tilts are, make sure that’s thoughtful. And hopefully it’s tilting towards areas that have historically shown to have higher expected returns. And I guess the last point that I’ll just say is, you
As a reminder is we are trying to improve our odds. We’re trying to become better investors to have better odds for success. It doesn’t mean guarantees. So keep trying to make better decisions with the data that you have. Also understand that the results may not always be there, but we know if we do this over a long period of time that the results will follow.
Marcus Schafer (51:38)
Wonderful. Thanks, Pat. Till next time.
Pat Collins (51:40)
Yep,
thanks.
Sources
- Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk (Sharpe, 1964)
- The Cross-Section of Expected Stock Returns (Fama & French, 1992)
- Common Risk Factors in the Returns on Stocks and Bonds (Fama & French, 1993)
- Returns to Buying Winners and Selling Losers (Jegadeesh & Titman, 1993)
- The Other Side of Value: The Gross Profitability Premium (Novy-Marx, 2013)
- Expected Returns (Ilmanen, 2011)
Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.