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47.  Factor Investing 101 : Part 4 - Implementing a Factor Portfolio Thumbnail

47. Factor Investing 101 : Part 4 - Implementing a Factor Portfolio

Chart 1 - DFA Global 60% Equity / 40% Fixed Income Portfolio - US Equity Sleeve to illustrate "tilting":

Tracking Error Regret - Chart #1 -2003 - 2007 (Source: DFA Returns Web)

Tracking Error Regret - Chart #2 -2008 - 2015 (Source: DFA Returns Web)

Detailed Show Notes:

Episode 47 – Implementing a Factor Portfolio

  1. Recap of our factors
  2. Describe how a factor portfolio is implemented 
  3. Describe some of the drawbacks of a factor portfolio
  4. Discussion on who should and shouldn’t use a factor portfolio

Recap of Our Main Factors

  • Equity
    1. Market Beta – stocks beat T-Bills
    2. Small Cap – small beats large
    3. Value – cheap beats expensive
    4. Profitability – More profitability beats less profitable stocks
  • Fixed Income
    1. Term – longer term bonds beat shorter term bonds
    2. Credit – corporate bonds beat government bonds

 Describe how a Factor Portfolio is Implemented

  • Equities - Ice Cube Tray
  • When you fill an ice cube tray and hold it flat, you have Market Beta
    1. All cells are filled equally
    2. You own large cap, small cap, value stocks, high profitability stocks, low profitability stocks
    3. You are also very well diversified – which is great – in a properly diversified portfolio, you want to get the return of the asset class (ie. US Stocks, Canadian Stocks) without any of the “idiosyncratic” or individual stock risk of a small set of companies **Concentrated Investing – future episode**
  • But, you don’t have factor exposure – you just have Beta (CAD/US/INTL/EM)
  • How do you get Factor exposure?
  • You “overweight” factors
  • US Equity Sleeve of the DFA Global 60% Equity/40% Fixed Income Portfolio
  • US Market
    1. 69% large cap, 21% Mid Cap, 10% small cap
    2. 37% value, 37% neutral, and 26% growth
    3. Equivalent to a TSM
  • DFA Tilted US Equity Sleeve
    1. 49% Large Cap (vs. 69%), 26% Mid Cap (vs. 21%), and 25% in small cap (vs. 10%)
    2. 52% Value (vs. 37%), 34% neutral (vs. 37%), and 14% in Growth (vs. 26%)
  • With the “Tilted” Portfolio, we are overweighting small cap, value, and profitability
  • We are still keeping some portfolio components in Large Cap/Growth because there are periods where they outperform 

Describe some of the drawbacks of a factor portfolio

  • “Tracking Error Regret”
  • This is the risk that a diversified portfolio underperforms a popular benchmark, such as the S&P 500.
  • To give you an idea, I’ll show you 3 different time periods to give you an idea of the danger of tracking error regret
  • **lots of numbers here - there will be detailed charts in show notes**
    1. 2003 – 2007 (4 years)
      • S&P total return was 83%
      • S&P TSX total return was 132%
      • MSCI EAFE Index total return was 171% (more than double)
      • MSCI Emerging Markets Index total return was 391% (almost 5x the S&P)
      • FACTORS:
        • MSCI US Small Cap total return was 116%
        • Fama French US Small Cap Value total return was 126%
    2. 2008 – 2015 (7 years)
      • S&P 500 total return was 66%
      • S&P TSX total return was 19%
      • MSCI EAFE Index total return was 0%
      • MSCI Emerging Markets Index total return was -21%
      • FACTORS:
        • MSCI US Small Cap total return was 82%
        • Fama French US Small Cap Value total return was 62%
    3. 2016 – Feb 2021 (5+ years)
      • S&P 500 total return was 107%
      • S&P TSX total return was 62%
      • MSCI EAFE Index Total return was 48%
      • MSCI Emerging Markets Index Total Return was 93%
      • FACTORS:
        • MSCI US Small Cap total return was 112%
        • Fama French Small Cap Value Research total return was 86%

The best guards against “tracking error regret”

  • Make sure you have a strong belief in the factors
    1. You don’t know which factors will outperform when, so you must be diversified across them at all times
    2. Typical investor considers 3-5 years a long time, and 10 years an eternity
    3. As we have just illustrated, premiums go through long periods where they don’t work
    4. Value, in the US, at the end of 2020 had gone through its largest 10-year drawdown in history
    5. But we know from history that 10 years is only a brief time period
    6. From 2000 – 2010, US stocks had a total return of -1% - did people give up on stocks?
  • Have a financial plan helps you keep a long-term view
    1. knowing that you’re investing for a long time, and that your goals are most often several decades long, it can bring perspective

Discussion on who should and shouldn’t use a factor portfolio

  • I can’t “wait” for factors to work 
    1. I am retiring soon
    2. I need to grow my money faster
  • People who say this have things exactly backwards
    1. Most people would nod if I said “you wouldn’t want to have all of your eggs in stocks as you approach retirement, or if you were on a short time period
    2. But, in the case of a US investor, they look at the performance of the S&P 500 over the past decade and said “I can just be in the S&P 500 and ignore factors” or “I can’t wait for value or small cap, or international/Canada/EM to start “working”
    3. What they are saying, in disguise, is that they are chasing performance of the thing that has worked well recently
    4. They have all of their eggs in one factor, that’s Market Beta 
    5. Even if you have Total Stock Market Funds for US/CAD/INTL, you are only exposed to Beta, and possibly term in your fixed income portfolio
    6. As we’ve seen above, Market Beta in the US went 10 years without any premium at all, while small cap and value and EM were doing great
    7. If you ignore factors, you are failing to diversify smartly across different sources of risk
    8. The shorter your time frame, the more important, I think, to diversify across factors
  • I think they only people who shouldn’t diversify in Factors are people who just cannot live with tracking error regret
  • Or, people that have so much money that they can afford to make a lot of mistakes and still be ok
  • As a retirement income planner, I think in 30 year time clips
  • For clients who are 40, if I’m planning their financial life until age 100, I’m thinking in a 60 year time clip
  • When I’m investing money for families, I have to ask myself “what approach gives me this family the best odds of success for the next 60 years”  
  • The answer is always going to be what the evidence supports.
  • Over multi decade, or multi-generational timeframes, the evidence is pretty overwhelming that this is the most logical way to invest money