Disclosure: A 1994 paper of mine is one of the 106 cited by the authors.
The 2008 stock market plunge induced many investors to seek diversification beyond the traditional vehicle of bonds. Unfortunately, write Andrew Berkin and Larry Swedroe in Your Complete Guide to Factor-Based Investing: The Way Smart Money Invests Today, such alternatives as private equity, hedge funds, real estate investment trusts, and infrastructure have fairly high correlations with equities. In place of asset class diversification, they recommend factor diversification as a more effective way to reduce portfolio volatility and market directionality. Factors are defined by the authors as “properties or a set of properties common across a broad set of securities.”
This solution, however, leads to another problem: Researchers have identified such a bewildering array of factors that John H. Cochrane of the University of Chicago has coined the term “zoo of factors.” Some 59 new ones were discovered during 2010–2012 alone, and a 2015 study covered 313.The practical challenge for investors is to identify a limited number of factors that truly enhance risk-adjusted returns.
To narrow down the list, Berkin and Swedroe, research directors at Bridgeway Capital Management and Buckingham Asset Management, respectively, establish several criteria for determining that a factor is genuinely helpful in an investment strategy. To make the cut, a factor must provide explanatory power for portfolio returns and demonstrate a record of delivering a return premium. The winning candidates must also be persistent, pervasive, robust, investable, and intuitive. Just eight factors meet this stringent test—market beta, size, value, momentum, profitability, quality, term, and carry.
Berkin and Swedroe are methodical and rigorous in their analysis, making use of the latest research findings. They cite 106 academic papers, including 33 from 2015–2016, and also present original findings. One especially noteworthy study, as summarized by the authors, suggested that Warren Buffett’s success is not attributable to stock-picking skills and discipline but to a combination of the leverage provided by Berkshire Hathaway’s insurance operations and concentration in large, cheap, safe, high-quality stocks.“Stocks with these characteristics tend to perform well in general,” the authors comment, “not just the stocks with these characteristics that Buffett buys.”
Berkin and Swedroe’s empiricism clears away many mistaken notions. Ultimately, however, assessment of their analysis involves some subjectivity. There is room for debate, for example, over the authors’ conclusion that low risk and default risk (aka credit risk) fail to make the cut.
Additionally, the authors acknowledge that for reasons explainable in terms of behavioral finance and market frictions, not all investors see the world in the framework of total return maximization/volatility minimization that they use throughout the book. The high-dividend and dividend growth factors do not pass the authors’ tests, but some investors irrationally (in the view of financial economists) prefer receiving dividends to creating “homemade dividends” by selling shares. Investment managers who deal with income-oriented individual investors will recognize this real-world obstacle to directly translating all of Berkin and Swedroe’s findings into their portfolio strategies.
Mindful of nonprofessionals’ incomplete knowledge of financial theory, the authors devote a full chapter to practical issues of implementation. They focus on inadequacies of the traditional approach to diversification, which consists of owning a total market fund. Simply holding both small-cap and large-cap stocks, as well as value and growth stocks, does not provide exposure to the small-cap or value factors, which requires long–short portfolios. Berkin and Swedroe show how to address this shortcoming through portfolio tilts.
Your Complete Guide to Factor-Based Investing is invaluable to practitioners aiming to design optimal portfolios. Assimilating the book’s lessons requires no extensive quantitative skills. The authors even provide definitions of such basic terms as “active management” and “risk premium.” Berkin and Swedroe also include an entertaining appendix on sports betting that tests whether behavioral pricing models explain value and momentum premiums across all markets.