Tilt Your Portfolio Correctly -> Outperform

Academic research and empirical evidence have identified certain styles of stocks that have historically achieved higher returns. Identifying and then overweighting towards these specific styles, called factors, can help patient investors outperform the general market.

It's not anything sexy such as predicting the next banking crisis or identifying the hottest biotech company. It's actually much more broad-based, and any investor can implement a factor "tilt" strategy in their portfolio to capture a bit of extra return over time.

Factor investing has gained popularity in recent years, especially in the Independent RIA Space. Rightfully so! Aspen Leaf Partners is no exception. However, the vast, VAST, majority of financial advisors don't follow the same research I do. They select investments largely Based On Past Performance, which has been proven to have its' shortcomings.

The consensus (mostly) in the research community is there are four factors investors should be paying attention to*. What's even more enticing is the factors have been relatively persistent across time, as well as across US, International, and Emerging Market stocks.

Value- unlike high flying "growth" stocks, these stocks generally trade at a lower price relative to their historical dividends, earning, sales, etc. There's nothing wrong with these stocks, they're just a little beat up is all. Historically, value stocks have outperformed their peers by 4.68%.

Small- we're all familiar with large company stocks like Microsoft and Amazon, but it's the smaller guys that actually pack a bigger punch. Small caps have bested large caps by 3.15%.

Momentum- easy to understand; stocks that have done well lately are likely to continue to do well (at least in the short term). Momentum stocks have trounced the market by 8.33%.

Profitability- duh, sounds obvious right? For the nerds reading this, profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book value. Oh yeah, and it's delivered a solid 3.72% outperformance figure too.

Pretty amazing numbers, right? Well, hold your horses. Those numbers don't reflect the actual trading costs to employ each strategy. Luckily, all four strategies have been confirmed to survive transaction costs**. Once fund operating costs are factored in, those outperformance numbers come down a bit- especially momentum.

To capture extra return (let's call it a premium), an investor has stick to the strategy- even through times it doesn't pay off. Premiums don't consistently show up in the data every day or month. Sometimes we don't see premiums in over a year. There is long term consistency, but investors should be prepared to forgo outperformance in the short term.

We can estimate the probability of earning a negative premium. For example, here's the probability the Profitability premium won't pay off over various time frames.

An investor has about a 75% shot at capturing the Profitability premium in any given year. The odds only get better when the holding period is extended.

Here's another way to slice it, this time looking at how small caps have compared to large caps. Here we're looking at the Dimensional US Small Cap Index minus the S&P 500 Index (U.S. large caps).

Blue bars indicate years where small caps outpaced large caps. Red bars represent years where large caps beat small caps. The consistency and scope of the small cap premium throughout 2000-2010 is rather impressive. Large caps delivered a paltry -0.9% over those ten years. Diversification matters!

I mentioned earlier factors don't just show in the US data. We find them outside our borders also.

Value stocks have outperformed growth stocks by an average of 0.4%, or 4.8% annualized over the last 30+ years***.

As you saw in the first two charts, premiums can disappear from time to time. It's entirely unpredictable. What's also a mystery is which factors will produce the biggest premiums in any given year.

Term and Credit are fixed income (bond) factors, and not something I wanted to dive into in this post. Low volatility is another very strong factor, but it hasn't completely passed the cost implementation test.

There wasn't room in this post to include every chart covering every factor for US, International, and Emerging Market stocks. Please use the Shoot Us An Email in the footer below if you'd like to see my 34 page slide deck covering the whole enchilada :)

Capturing the factors isn't all that complicated. We start by buying the entire market, and then overweighting stocks that exhibit factor characteristics. Stocks that don't meet our factor criteria are underweighted, or sometimes left out of the portfolio. This is the "tilt" I mentioned at the beginning of the post.

To employ a factor investing strategy, there are a few options. The easiest is to work with an advisor approved to use Dimensional Fund Advisors (DFA) funds. They are only sold via accrediated advisors, meaning, you can't buy them yourself on eTrade. DFA pioneered the concept of bringing together research from Nobel Prize winning research and low cost, Passively Managed funds.

If you're a do-it-yourselfer, you might want to check out the newly released Factor-Based ETFs from John Hancock. Being new releases, they have zero track record, but they use DFA as a subadvisor. We can assume they'll achieve the same great results DFA has been deploying to investors for over 40 years. You could combine a few of the John Hancock ETFs with the iShares, who offer a riduculously inexpensive ETF to help capture the momentum premium.

If you actually made it this far into the blog post and are throwing up your hands (or just throwing up), consider asking me how I blend together factors. It might be something I could help you achieve. To read my company's Investment Philosophy and more detail on another emerging factor- ESG tilting, click HERE.

I hope factor investing combined with broad market exposure will continue to gain popularity. It's a bit different than the conventional money management tactics of market timing and individual stock picking. For patient investors, it provides the only consistent strategy proven to eke out a bit of marginal gain over the market.

* How The Four Stock Premiums Work. Swedroe, April, 2012 & The Other Side Of Value: The Gross Profitability Premium. Novy-Marx, June, 2012 & Can ESG Add Alpha? Nagy, Kassam, Lee, June, 2015.

** Trading Costs of Asset Pricing Anomolies, Frazzini, Israel, & Moskowitz, Dec, 2012, and A Taxonomy of Anomolies and Their Trading Costs, Novy-Marx & Velikov, Dec, 2014.

*** Chart courtesy Dimensional Fund Advisors. Data for countries that include an * in the name begin in 1990.