Six months ago, Charley Ellis discussed in these pages how improvements in computer power, greater interest in MBA programs and much higher compensation has increased competition within the investment industry (“Competition Has Made Indexing a Winner’s Game,” November 2016 AAII Journal). One way these trends have manifested themselves is in the search for anomalies. Anomalies are factors influencing a security’s returns unexplained by the capital asset pricing model. (The CAPM calculates returns as the volatility-adjusted premium over a risk-free asset.)

Research efforts into ways to earn a premium return have likely occurred since financial markets first existed. If there is a chance to make money, someone is going to work on a way to make more of it.

In the field of investing, we’re seeing this innovation partially play out in research on anomalies (aka factors). It’s being pitched under the snazzier term of “smart beta.” Some of the research is straightforward; some of it is more esoteric. So much research in the subject has been done that former American Finance Association president John Cochrane once wrote, “Now, we have a zoo of new factors” (The Journal of Finance, July 19, 2011).

Cochrane was referring to the large number of characteristics identified by researchers. He referenced the difficulty of trying to assess distinct drivers of returns among 27 variables in his article. BAM Alliance director of research Larry Swedroe says the investment literature has now identified more than 600 factors. Good luck creating a portfolio based on more than 600 factors, or even 27 for that matter.

Finding unique variables gives those in academia as well as professionals something to write about. Someone who is managing money or looking to launch a new exchange-traded fund (ETF) may find it useful to try to exploit a less-followed factor.

Though factors continue to be an area of focus for Wall Street, they aren’t new. Benjamin Graham advocated for value investing, Thomas Rowe (T. Rowe) Price Jr. honed in on growth stocks. Charlie Munger convinced Warren Buffett to consider quality before the terms “factor” and “smart beta” entered the investment industry’s lexicon.

Many of you are even actively using strategies tied to specific factors without realizing it. Value, momentum and dividend investing are all forms of factor investing. Even our Model Shadow Stock Portfolio could be classified as a smart beta strategy. It uses quantitative analysis to take advantage of the small-versus-large (“size”) and the high-minus-low (“value”) anomalies, overlaying quality and momentum factors. (Value is defined as high minus low because the research was done by looking at book-value-to-market-capitalization ratios, which are the inverse of price-to-book-value ratios.)

The difference between how you and I utilize factors and what much of the research shows is leverage. The small-versus-large anomaly, for instance, assumes an investor will buy, say, the smallest 30% of stocks as ranked by market capitalization and short the largest 30% of stocks. The profit made by this strategy is known as the small-cap premium. Put another way, it is the excess return realized by small-cap stocks relative to large-cap stocks. This exercise works well for proving the existence of an anomaly, but due to costs and logistical constraints, it’s not easy to effectively implement in a real-world scenario.

Fortunately, you don’t have to worry about buying and simultaneously selling short to capture factor premiums. You can simply orient your portfolio based on the individual factors—and not all 600 nor even 27, but rather just a small number. Swedroe suggests six: market beta, size, value, momentum, profitability and quality. Though his article about factors, which starts here, discusses investing at the portfolio level, the factors can be applied to individual stock selection as well.

There will be more discussion about factor investing at our upcoming Investor Conference. Not only will Larry speak, but so will Wesley Gray (whose firm has done much research into the subject) and Bill Belden of Guggenheim Investments (who will talk about his firm’s equal-weighting approach toward market capitalization.) You can find out more information at www.aaii.com/conference. I hope to see you there.

Wishing you prosperity,

Charles Rotblut, CFA
Editor, AAII Journal
@CharlesRAAII