The world of investments is constantly evolving. The latest investing trend is “ESG” (Environmental, Social and Governance); investing in companies that reflect characteristics considered positive for society. Another recent trend supported by much academic research is “factor” investing; investing in companies that show a clear statistical bias to outperform broad indices over a long period of time based on their underlying characteristics.
The four major characteristics that show the best statistical outperformance are momentum (positive trending performance, MTUM), minimum volatility (relatively less risky, USMV), size (small company, SIZE), and quality (good financial condition, QUAL). In theory, adding an overweight to positions in these kind of stocks will add incremental return to beat the broad benchmark. Let’s see how these have done over the recent past and longer term.
The recent history has been kind to factor investing, but not so good over the past 3- or 5-year history. As seen from the table below as of January 31, 2023, both the size and value factors have shown recent consistently good relative outperformance (green text highlighted) and added value to a portfolio, but over longer time frames none of the factors have outperformed the broad S&P 500 (IVV) benchmark.
Granted, the past 5 years have been extraordinarily unusual with the global pandemic and historically low interest rates followed by an interest rate tightening cycle, so perhaps the time horizon has not been long enough for the statistical bias to emerge. Or, perhaps the underlying portfolio rebalancing of the factor ETFs has not matched with the shifts in the market so as to miss the inflection points where cycles may have started to shift.
Regardless of the reason for the longer term underperformance, placing positions in any of these factor investments, in addition to the broad indices, adds to the overall diversification of a portfolio and we expect that will lead to outperformance over time.