The Science of Investing Moves Forward: Part Two

In a previous article, I explained how research by financial academics opened the way to building a better, more diversified portfolio. In particular, they showed how diversifying with “Factors” (or what can be called “drivers of return”) – market, small and value – could improve a stock portfolio’s risk-adjusted returns compared to a traditional stock portfolio that was invested primarily in large U.S. stocks.

Well, luckily for investors, recent research has uncovered additional factors that drive stock returns. And like their predecessors, these new factors can be used to improve returns. In essence, they’ve figured out how to build a better mousetrap.

So what are these new factors and how can they help?

The first new factor is called Gross Profitability. Researchers discovered that companies with certain types of profits and certain other attributes tended to outperform companies without them. (Basically, researchers were able to crack Warren Buffett’s code. It turns out that Buffett’s genius wasn’t in his ability to pick stocks but to discover an unknown factor and ride it as much as possible.)

A study by University of Rochester finance professor Robert Novy-Marx showed that firms with the top amount of gross profitability earned 0.31 percent per month higher average return than firms with the least amount of gross profitability.

In addition, Novy-Marx showed that the gross profitability factor mixed extremely well with the value factor. That’s because the gross profitability factor tends to do well when the value factor is doing poorly and vice versa. (In statistics parlance, they are negatively correlated, which is the Holy Grail of portfolio design.)

For example, Novy-Marx showed that the monthly average returns to the profitability and value strategies are 0.31 and 0.41 percent per month, respectively, with standard deviations of 2.94 and 3.27 percent. However, an investor running the two strategies together would almost capture both strategies’ returns (0.71 percent per month) with no additional risk (2.89 percent).

Higher returns for an equal amount of risk. When it comes to investing, that’s about as good as it gets. (Granted, in the real world, we won’t be able to capture the entire gross profitability factor – much like we’re only able to capture around 50 to 60 percent of the value factor – so our returns will be less than shown by Novy-Marx. However, half of a good thing is still a lot better than nothing at all.)

Researchers also confirmed another factor known as Momentum. As the name implies, momentum is based on massive data that stocks that have done well recently tend to keep doing well for short periods. (Conversely, stocks that have done poorly recently tend to keep doing poorly for short periods.)

To be honest, I – along with much of the science-based investing world – was always skeptical of momentum. I mean, it just sounded too simplistic and, frankly, a bit goofy. If it really existed, wouldn’t stock traders take advantage of it to the point that it disappeared?

So we all waited for researchers to poke holes in the momentum factor. Instead, they proved its existence in foreign stocks markets, other types of markets, such as bonds, and at various other time periods in history. In essence, researchers bolstered momentum’s case to point where it was impossible to disregard.

Researchers also discovered that momentum – much like gross profitability – worked extremely well with the value factor. Again, like gross profitability, momentum tended to do well when value was doing poorly and vice versa.

The mutual fund company Dimensional Fund Advisors (DFA) looked at what impact incorporating a momentum screen into their value funds would have on returns. Examining the data for 2006 to 2009, they determined that adding momentum screens would have increased the overall returns by the following amounts over the three-year period:

Fund                                                   Added Total Return

U.S. Small Cap Value                                      10.9%

U.S. Large Cap Value                                     8.5%

International Small Cap Value                     16.3%

International Value                                        3.9%

What happens when you combine all value, momentum and profitability?

Over the July 1963-December 2011 period, Novy-Marx found that a dollar invested in large U.S. stocks, i.e. stocks that didn’t have the momentum, value or profitability factors, would have grown to more than $80; a dollar invested in large-cap winners (momentum stocks) would have grown to $597; a dollar invested in cheap large-cap winners (value and momentum) would have grown to $411; a dollar invested in profitable, cheap large-cap stocks (profitability and value) would have grown to $572 dollars; and a dollar invested in profitable, cheap, large-cap winners (profitability, value and momentum) would have grown to $955.

Given that trading costs are relatively low in large cap stocks, even if turnover for a combined strategy was fairly high, the strategy would still result in much higher returns.

Another benefit to combining all three factors is more consistent performance. A recent paper by AQR Capital Management, “A New Core Equity Paradigm: Using Value, Momentum, and Quality to Outperform Markets,” which covered the period since 1980 in the U.S. and since 1990 in international markets, found that a portfolio of value stocks experienced significant five-year periods of under performance compared to large, non-value U.S. stocks (which is what most people use gauge the performance of their stock portfolio), while the combined portfolio of value, momentum and gross profitability effectively eliminated any such episodes, outperforming the market in every five-year period historically.

Adding profitability and momentum historically has created portfolios that increase returns, lower risk and have more consistent performance. That’s what I can a breakthrough.

About Mark Helm, CFP, EA

Mark Helm is a Certified Financial Planner and Enrolled Agent. He is the founder of Helm Financial Advisors, LLC, a fee-only financial planning firm dedicated to helping people reach their life goals.
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1 Response to The Science of Investing Moves Forward: Part Two

  1. Pingback: Stocks and Bonds Aren’t Enough: You Need Strategy and Geographic Diversification as Well | Mark on Money

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