Factor-based
investing:
The
buck stops
here:
an overviewmoney market funds
Vanguard
Vanguard research brief
Key points
n Factor-based investing
seeks to achieve
specific investment
risk-and-return
outcomes, potentially
in a cost-effective,
transparent manner.
n When evaluating
factors, advisors
should consider their
clients’ tolerance for
performance cyclicality
and active risk, as
well as the rationale
supporting specific
factors.
n We believe a market-
cap-weighted index
is both the best
representation of an
asset class and the
best starting point for
portfolio construction
discussions.
April 2015
Financial advisors, commentators, and academic
researchers have paid increasing attention
to factors in recent years.
So what are factors? And can they be part
of an enduring portfolio?
discussed factors and the findings of collective
research. Note that even in the case of a
market-capitalization-weighted stock portfolio,
something must explain the portfolio’s risk. In
this case, it’s the market factor, or what we
might more commonly call equity risk.
This brief, based on Vanguard research,1
explores the underlying exposures, often
referred to as factors, that explain and influence
an investment’s risk. Our research considers
these exposures as they’re integrated into
portfolio construction.
Similarly, value investing can be considered
a type of factor-based investing. Rather than
diversifying across an entire market, value
investors focus on subsets of stocks with
attractive valuations.
Academic research provides empirical evidence
of historical excess return for an array of factors.
Figure 1 lists some of the more commonly
Over time, style indexes have been developed
to better measure style investors’ performance
and to provide for passive vehicles seeking to
replicate active investors’ returns.
Figure 1. Sample stock and bond factor exposures
Description
Market
Stocks have earned a return greater than the risk-free rate.
Value
Inexpensive stocks have earned a higher return than expensive stocks.
Size
Stocks of small companies have earned a higher return than stocks of large companies.
Momentum
Stocks with strong recent performance have earned a higher return than those with
weak recent performance.
Low volatility
Stocks with low volatility have achieved a higher risk-adjusted return than those
with high volatility.
Term
Long-maturity bonds have earned a higher return than short-maturity bonds.
Credit
Lower-credit-quality bonds have earned a higher return than higher-credit-quality bonds.
Source: Vanguard.
FOR FINANCIAL ADVISORS AND INSTITUTIONS ONLY. NOT FOR PUBLIC DISTRIBUTION.
1 Scott N. Pappas and Joel M. Dickson, 2015. Factor-based investing. Valley Forge, Pa.: The Vanguard Group.
The research behind factors
Academic research has found that factor exposures
explain much of the risk or return characteristics across
a range of investments, including alternatively weighted
indexes and traditional active manager portfolios.
Factor-based investing has the potential to improve riskadjusted returns when implemented alongside various
investment portfolios, according to the research. This
includes a 60% U.S. stocks/40% U.S. bonds portfolio;
diversified funds that include global stocks and bonds,
emerging markets, property, and commodities; alternative
assets; and active portfolios.
The body of academic research is discussed in our
full research paper Factor-based investing, by
Scott N. Pappas and Joel M. Dickson.
Practical considerations
While academic research demonstrates the potential
benefits of factor-based investing, a number of issues
can affect the success of the approach.
Implementation. Actual performance of factor approaches
may differ from performance reported in academic
research. These differences will vary depending on the
factor in question. For example, factors associated with
small or illiquid stocks may present capacity and liquidity
issues that don’t affect other factors.
Selecting factor exposures. What is a factor—and what
isn’t? Unfortunately, there’s no definitive list. Some factors
have shown a strong relationship in explaining volatility of
returns but haven’t generated excess returns themselves.
Other factors historically have produced excess returns,
but it’s unclear whether these returns can continue into
2
the future. Advisors should be aware that diversification
benefits may be limited if portfolios aren’t effectively
diversified across a range of distinct factors.
Explaining factor returns. Risk and investor behavior
help explain the returns that factors provide. The risk
explanation suggests that return premiums are rewards
for bearing risk or uncertainty. The behavior explanation
suggests that investors’ systematic errors result in
distinct patterns in investment returns, such as those
seen in the momentum effect (see Figure 1, on page 1
for a description).
Future return premiums. Will historical factor returns
persist? If the behavioral explanation of returns holds true,
a risk exists that investors may adapt, causing the
premium to disappear.
Return cyclicality. Individual factors may underperform
for extended periods. Though not unique to factor-based
investing, this risk helps make the case for diversification
among factors and highlights the need for investors to be
able to “stay the course” in challenging times. Figure 2
shows how the top performers among factor-based
investments have changed over time.
Applications of factor-based investing
We believe that constructing a portfolio to obtain factor
exposures is an active decision, because advisors tilt away
from broad asset-class representations. A tolerance for
active risk is important for advisors who embrace factors.
Figure 3 shows return and volatility for the seven
factors our paper discusses. Factor implementation
can be achieved in many ways, which can result in
performance differences. Figure 3 shows long-only and
long/short implementation for four of the factors.
Figure 2. Changing performance leadership
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
Best
performer
n Term
n Credit
n Value
n Market
n Momentum
n Size
n Low volatility
Worst
performer
Notes: Returns are U.S.-dollar-denominated excess returns greater than the “risk-free” rate. Market factor is calculated using MSCI All Country World Index (total return); momentum factor
is calculated using global large-capitalization high-momentum portfolio (see Kenneth R. French’s website); value factor is calculated using global large-cap value portfolio (see Kenneth R. French’s
website); term factor is calculated using Barclays Global Treasury Index (total return); credit factor is calculated using Barclays Global Credit Index (total return); low-volatility factor is
calculated using MSCI World Minimum Volatility Index (total return); size factor is calculated using MSCI All Country World Small Cap Index (total return); risk-free rate is calculated using
the one-month LIBOR (London Interbank Offered Rate) rate. Data cover the period from January 1, 2005, through December 31, 2014.
Past performance is no guarantee of future results.
Sources: Vanguard calculations, using data from FactSet and Kenneth R. French’s website, mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html.
Figure 3. Factor-based investment excess returns and volatility
Market
Value:
Size:
Momentum:
Long/short Long-only Long/short Long-only Long/short Long-only
Term
Credit:
Long/short Long-only
20%
15
15
10
10
5
5
0
0
–5
Annualized return volatility
Annualized excess return
20%
Low
volatility
–5
Annualized return volatility (%)
Notes: Returns are U.S.-dollar-denominated excess returns above the risk-free rate. The market factor is calculated using MSCI All Country World Index (total return); the low-volatility factor
is calculated using the MSCI World Minimum Volatility Index (total return); the long/short value factor is calculated as the global large-cap value portfolio minus the global large-cap growth
portfolio (see Kenneth R. French’s website); the long-only value factor is calculated using the global large-cap value portfolio (see Kenneth R. French’s website); the long/short size factor is
calculated as MSCI All Country World Small Cap Index (total return) minus MSCI All Country World Large Large Cap Index (total return); the long-only size factor is calculated using MSCI
All Country World Small Cap Index (total return); the long/short momentum factor is calculated as the global large-cap high momentum portfolio minus the global large-cap low momentum
portfolio (see Kenneth R. French’s website); the long-only momentum factor is calculated as the global large-cap high momentum portfolio (see Kenneth R. French’s website); the term factor is
calculated using Barclays Global Treasury Index (total return); the long/short credit factor is calculated using Barclays Global Credit Index (total return) minus the duration-matched Barclays
Global Treasury Index; the long-only credit factor is calculated using Barclays Global Credit Index (total return); and the risk-free rate is calculated using the 1-month LIBOR rate.
Past performance is no guarantee of future results.
Sources: Vanguard calculations, using data from FactSet and Kenneth R. French’s website, mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html. Data cover the period from
January 1, 2000, through December 31, 2014.
3
Potential benefits of factor-based investing
A few final thoughts
Many assets, whether index or active, have underlying
exposures to common factors. Advisors can access
factors in several ways, and some do so unintentionally.
An explicit focus on factors offers potential benefits in
terms of:
We believe a market-capitalization-weighted index is the
best starting point for portfolio construction discussions.
Factor-based investing actively positions portfolios away
from market-capitalization weights in an attempt to
achieve specific risk-and-return outcomes. While an
explicit focus on factors may offer potential benefits in
terms of transparency, control, and cost, advisors should
consider their clients’ tolerance for active risk and swings
in performance, as well as the investment rationale
behind specific factors.
• Transparency: By deliberately focusing on factor
exposures in portfolio construction, investors may gain
a clearer understanding of the drivers of portfolio returns.
• Control: A portfolio may be exposed to factors
through a variety of investments. For example,
some fundamentally weighted indexes provide a
value factor exposure that varies over time. In contrast,
an investment that explicitly targets the value factor
may provide a more consistent exposure. It’s important
for investors to consider whether to delegate factor
exposure to a manager or index or to maintain direct
control over factors.
Visit advisors.vanguard.com/briefs for research briefs
versioned for advisors and clients on a broad range of
timely topics.
• Cost: In some cases, investors may pay high fees to
obtain factor exposures that are available more costeffectively by allocating directly to a factor.
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Past performance is no guarantee of future results.
All investing is subject to risk, including possible loss of principal.
In a diversified portfolio, gains from some investments may help offset losses from others. However, diversification does
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