Long-term investors can easily enhance their portfolio returns by tilting their equity allocation toward investment factors that have produced reliable risk premiums.

According to a professor at Spain’s IESE Business School, when investors want to enhance their returns, tilting their equity allocations toward overweight positions in small-cap and value stocks results in benefits that cannot be reproduced by optimizing broadly diverse, low-cost stock-bond portfolios with more aggressive asset allocations.

The study used a traditional 60% large-cap stock and 40% bond allocation as its benchmark portfolio. It then considered various factor-enhanced portfolios of exchange-traded funds (ETFs). These latter portfolios added small-cap stocks and/or value stocks.

In all cases of the study, the total allocation of its tested portfolios remained at 60% stocks and 40% bonds. The only differences across the factor-enhanced portfolios were the exposure to broadly diversified stocks, which was either 20% or 40%.

Although adding factor ETFs (value and/or small-cap funds) may increase the complexity of a portfolio and the fees charged to it, the benefits obtained outweigh the costs.

Specifically, a traditional 60/40 stock-bond portfolio optimized to match the return or volatility of a factor-enhanced stock-bond portfolio experienced higher volatility and lower compounding power. In other words, the risk-adjusted return of the traditional 60/40 portfolio turned out to be lower than the factor-enhanced portfolios.

The study’s author initially used the period of 1927 to 2018. A bigger advantage to incorporating factor tilt (value and small-cap stocks) was found when the more recent period of 1999 through 2018 was used.

Portfolio construction also mattered. Its magnitude of the difference in returns was greater when Vanguard funds were used than when Russell and Bloomberg Barclays funds were used. The benefits of factor tilting can be obtained with traditional small-cap, value or small-cap/value funds as well as smart-beta funds, including those offered by other companies than Vanguard.

The author theorized that the study’s results were due to the well-known size and value effects, which are the two most widely researched factors. The size effect refers to the tendency of small-cap stocks to outperform large-cap stocks. The value effect refers to the same tendency but in reference to cheaper stocks’ outperforming relatively expensive stocks.

Source: “Factor Tilts and Asset Allocation,” by Javier Estrada; SSRN, November 2019.