Studies have shown that factor tilts add more portfolio alpha over time than manager selection. The concept was formalized and later expounded on by Eugene Fama and Kenneth French, who, in their three factor model, found that over the long term small stocks will outperform large stocks, and value will outperform growth. Since the model’s 1992 publication, new factors have been embedded into indexes and investment vehicles.
Risk/return win: Much as with security selection, making the right call in factor selection can be difficult. Over time, factor bets have outperformed the broad market in risk-adjusted returns.
Low alpha correlations: Correlations of factor index returns are high, but among alphas over the base index they’re low or negative. Despite offering better tactical returns, timing when each will fall in or out of favor is the hard part. Combining too many factor strategies will diminish alpha.
Buying in: Investor demand for factor ETFs has grown steadily, with some factors less consistent than others. Dividend-focused funds have had the strongest demand, while low-volatility and momentum-interest funds have been more varied with market conditions.
Tops in factors: Dimensional is the largest manager in factor investing, with almost 100% of its $453 billion AUM tilted to size, value and profitability factors.
*Russell 1000 factor indexes used as performance proxies, index returns relative to the Russell 1000 index are used for alpha terms. Sources:
Northern Trust Asset Management; ETFGI; P&I Research Center; Morningstar
Compiled and designed by Charles McGrath and Gregg A. Runburg