A while back I wrote about some historical analysis I had done that showed several ways that an investor could achieve market beating returns and thus maximize retirement income. It has been known for a long time that several ‘factors’ or characteristics of stocks generate market beating returns. The two classic factors are value and size. Value stocks outperform the market over long periods of time. Small cap stocks outperform as well. The third and newest factor, at least relative to value and size, is momentum. I also showed that contrary to efficient market theory these extra returns do not come with extra risk, or that the extra risk, is more than compensated by extra return. Below I reproduce the key table from that post.
Now, the question that I left open at the time is how does an investor best gain exposure to these market beating factors? That’s what I’d like to talk about briefly in this post. Briefly because its pretty simple. The best way to gain exposure to the value and size factors is through ETFs. I’ll come back to momentum in a bit. Today there are a ton of ETF offerings in the value and small cap styles for an investor to choose from. And ETFs that combine small cap and value. For, example, here is a list from ETFdb of all the value ETFs they keep track of. There are 100 ETFs on the list. The small cap list has 107 ETFs. By the way, for dividends fans like myself out there, dividend ETFs for the most part are considered as value investments. As far as selecting ETFs, I always start with Vanguard first (because fees matter a lot and they have the lowest overall fees) and then go from there, unless I’m looking for something very specific. I would then look for the ETF on my broker’s commission-free ETF list to further reduce my cost (here is the list for my broker TD Ameritrade). Below are the Vanguard choices for value and small cap stocks.
That’s the easy part, finding value and small cap ETFs. The harder part is constructing portfolios around them. But its not all the difficult either. You start with the concept of holding a broadly diversified portfolio and then add value and small cap exposures to it. Lets look at an example using the IVY portfolio as a model to start from. In the table below I picked out a few value and small cap offerings and inserted them into the overall IVY allocation. The concept is the same whatever your starting portfolio, 60/40, Permanent Portfolio, etc… Notice that there are even value ETFs for the real estate sector. There are tons of ETFs out there and these are by no means meant to be the ‘best’ ETFs for value and small size.
I chose allocation percentages that I see recommended often. Basically, they have the majority of the allocation to the broad index in a given asset class and then gain exposure to factors like value and size through small allocations to them (e.g the 5% allocation to VBR). Now, if value and size give an investor such outperformance over the long run why not have all of the asset allocation geared towards these factors? Like any strategy there will be periods of time when it will outperform and periods of time it will underperform. Anyone remember for how long value stocks underperformed in the late 90s tech bubble? I think it was 6-7 years. Most investors don’t have the emotional tolerance to underperform the market for extended periods of time and often end up abandoning strategies like value investing during those times, even though over the long run they would be better off. But you have to respect investor psychology and adjust portfolios accordingly. If you are a tried and true value or small cap investor maybe you could have equal allocations among a broad index and the factors like value and size.
What about the last factor, momentum? This one is a bit harder because only recently have ETFs been announced to gain exposure to momentum. The ETFdb list only shows 3 momentum ETFs so far. Probably a bit early to include one of these in a portfolio allocation. I’d like to see then grow in size and see how well they do. So, lets leave it at that for now. But this does bring up another way that many professional investors and funds gain exposures to the factors I’ve discussed here (value, size, and momentum) and many others. It’s called Quantitative Investing. In the simplest sense quantitative investing is basically mechanical investing, the use of a computer to choose a portfolio of stocks based on any factor an investor chooses. Usually quant strategies are associated with very complex models that are used by large hedge funds (see here) but that doesn’t have to be the case. They can also be quite simple. I’ll be introducing the concept more in subsequent posts and how it can be simple and applied by individual investors.
In summary, an investor can increase portfolio returns over the long term by tilting their portfolios to factors that have been proven to outperform the market over time. Size, value, and momentum have been proved to increase investor risk adjusted returns and also increase withdrawal rates in retirement. Investors should consider allocation and least some of their assets to these factors.
Full Disclaimer - Nothing on this site should ever be considered advice, research or the invitation to buy or sell securities. These are my personal opinions only.