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Can factor-based ETFs reduce volatility – and beat the market?

Andrew Hallam is the index investor for Strategy Lab. Globe Unlimited subscribers can view his model portfolio here and read more in the series online here.

Dave Hook's life has changed quite a bit over the past few years. He and his wife Gail moved to Victoria in 2014, after 38 years in Barrie, Ont. Like many working couples, they added money to their investment portfolios while Dave worked as a sales manager for a U.S.-based chemical manufacturer. Gail was an elementary school French teacher.

But now they're retired. The 70-year old couple will soon be converting their RRSPs to RRIFs. Dave has been adjusting their portfolios. They'll soon be withdrawing money, so Dave wants the portfolios to be as simple as possible. "We're moving them towards fully indexed models," he says, "with about 60 per cent in equities and 40 per cent in bonds."

But that doesn't mean they'll stick with plain vanilla indexes. They own some factor-based ETFs. These funds could reduce their volatility and beat the market. Sound impossible? U.S.-based financial authors Andrew Berkin and Larry Swedroe say it isn't. They recently published Your Complete Guide To Factor-Based Investing.

Factor-based funds focus on specific types of stocks. For example, value stocks are a type of factor. They're cheap. They don't beat the market every year (nor every decade) but over longer time periods, they usually do. First Asset's Morningstar Canada Value Index ETF (FXM) and iShares Canadian Value Index ETF (XCV) are both stuffed with value stocks.

Size is another factor with market-beating potential. Small stocks usually outperform large stocks. Fund managers who lump small-cap stocks into a single fund are betting that the size factor will work. An example of a Canadian small cap ETF is the iShares S&P/TSX Small Cap Index ETF (XCS).

Momentum is another factor. Popular stocks rise quickly in price. Those that gain strong momentum tend to maintain that trajectory – at least for a while. Fund managers who fill these stocks into a single fund try to use the momentum factor. Such funds include First Asset's Morningstar Canada Momentum ETF (WXM).

The book by Mr. Berkin and Mr. Swedroe dives into several different factors. They tested them to see whether they beat the market over the long-term and whether they worked outside of the United States. They also looked beyond theory. They wanted to see whether such funds in the United States performed as they were supposed to.

According to their research, they have. But factors can sometimes disappoint. They don't always win. Those that win over one time period often lose the next. That's why the authors say investors can reduce their risk by diversifying across several different factors. They measured the odds of different investment factors outperforming the U.S. market between 1927 and 2015.

For example, they say there's a 63 per cent chance that value stocks would beat the market over a one-year period. Over three-year periods, those odds improve to 72 per cent. Their odds of beating the market increase to 94 per cent over 20 year periods.

Mr. Berkin and Mr. Swedroe then looked at three different portfolio allocations. Their first portfolio model was an even split between four different factors: market beta, size, value and momentum. When tested on U.S. stocks, the portfolio's odds of beating the market were higher than with any single factor. Over a one-year period, it had a 77 per cent chance of beating the market. That increased to a 90 per cent probability over three years, a 95 per cent chance over five years, a 99 per cent chance over 10 years and a 100 per cent probability of beating the market over a 20-year period.

That's why investment firms are jumping on the multi-factor wagon. Last year, iShares offered its Edge MSCI Multi-Factor Canada Index ETF (XFC). Similar to the authors' models, this ETF applies four different factors: value, small size, momentum and quality. iShares also has a U.S. stock version (XFS) and an international stock market equivalent (XFI).

Will regular index funds soon be horse-drawn buggies? I don't think so. For starters, past performance might not be a window to the future. Mr. Berkin and Mr. Swedroe found that once a strategy becomes well known, it fires on fewer cylinders.

Also, most index fund investors need to worry about only one thing: how the market will perform. With factor-based models (as with actively managed funds) investors add another worry. They question how their fund will perform, compared to the market. They might also worry whether a different factor-based fund or a different combination of factors will perform better than the ones they've picked.

This could cause investors to move in and out of funds. By doing so, they could end up buying high and selling low. Factor-based models offer a lot of promise. But it might be better to keep things simple. Investment behaviour is the factor that few of us can harness.

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Odds Of Factors Outperforming The Market

1927-2015

FactorOne-YearThree-YearFive-Year10-Year20-Year
Value63%72%82%90%94%
Market Beta66%76%82%90%96%
Size59%76%70%77%86%
Momentum77%86%91%97%100%
Profitability63%72%77%85%93%
Quality65%75%81%89%96%
Portfolio 177%90%95%99%100%
Portfolio 283%95%98%100%100%
Portfolio 387%97%99%100%100%

Source:  Andrew Berkin and Larry Swedroe, Your Complete Guide To Factor-Based Investing. Notes: Portfolio 1 = 25% market beta, 25% size, 25% value, 25% momentum. Portfolio 2 = 20% market beta, 20% size, 20% value, 20% momentum, 20% profitability. Portfolio 3 = 20% market beta, 20% size, 20% value, 20% momentum, 20% quality

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