In Part 1 of this blog, we explored the theory behind Fama-French Three-Factor Model. In Part 2, we explore its practical application.
The Fama-French Three-Factor Model can be used two ways. First, it can be used to peer into portfolio returns and analyze results. Second, it can be used to engineer portfolios based on refined risks and expected returns.
One asset management company has excelled in creating products using Fama-French research. Dimensional Fund Advisors, more commonly known as DFA, has invested a considerable amount of time and money over the past 15 years in an attempt to educate investment advisors on three-factor portfolio construction. They have hosted dozens of seminars in the U.S. and abroad, as well as created written web content, podcasts and videos.
DFA’s idea is to teach advisors about portfolio engineering so that those advisors will employ this strategy with their clients. In turn, they will use the mutual funds and other products that DFA designed for this purpose. The New York Times personal finance reporter, Ron Lieber, attended a DFA advisor seminar this year and provided a rare peak into this world in Finding Success, Passionate Followers in Tow.
DFA’s success promoting three-factor investing has not gone unnoticed. Competing fund companies have recently jumped on the bandwagon and are promoting their own three-factor funds. One company is Research Affiliates (RA). They develop three-factor indexes using a method dubbed Fundamental Indexing (FI). RAFI-driven portfolios overweigh fundamentally attractive value stocks and deemphasize growth stocks. Several fund companies have licensed RAFI products over the past few years.
Northern Trust has recently entered the three-factor fund space with the launch of the FlexShares Morningstar U.S. Market Factor Tilt Index Fund (Symbol: TILT). This fund seeks to capitalize on the model by “tilting the portfolio toward the long-term growth potential of the smaller cap and value segments.”
Three-factor investing is becoming increasingly popular with investors, advisors and fund companies. That should be a warning to you. This is a risk story, as well as a return one. At times, small cap value stocks underperform the market by a meaningful amount — and for extended periods of time. Wise investors are aware of these risks.
On average, small cap stocks underperform the market in one year out of three. Figure 2 illustrates five-year annualized performance of small-cap value stocks relative to the U.S. total stock market since 1980. Small cap value investors were not happy campers during the second half of the 1980s or 1990s. The illustration below was formed using returns from the Ken French data library.
Figure 2: The Variability of Three-Factor Returns
One unusually high period of outperformance for small cap value stocks over the rest of the market occurred between 2000 and 2004. During this time, small value delivered an incredible 21.3 percent excess annualized return. The remaining years in the decade were not as high, but still positive. In total, the performance of small value from 2000-2009 has easily been the highest relative performance to the total market in 60 years.
Given the extremely high, recent relative performance of small cap value investing, it should be no surprise that DFA has been able to attract thousands of advisors to their seminars in recent years. This begs the question, will the strategy outperform in the future? It’s difficult to say.
I do believe prudent investors and advisors should expect much less from three-factor investing than in the past decade. Small value stock performance has fallen below the markets since 2010, but that could change overnight.
My recommendation to investors is to approach three-factor portfolio engineering with a clear mind, realistic expectations, and a very long-term commitment. Success follows discipline. If you go down this path, you should stand ready to adopt multi-dimensional investing as your life-long investment philosophy.
