In today’s episode, we beg the question: is factor investing worth it? Factor-tilted portfolios tend to perform independently of the market and today, we break down a few of the characteristics associated with higher expected returns, as well as the challenges of factor investing. We give a brief history of pricing models and walk step-by-step through a hypothetical factor investment; taking the Fama and French five-factor model into account. Additionally, we discuss liability duration and bond returns and speculate whether pooling finances results in greater relationship satisfaction. Tune in to hear our take on everything from book clubs and the impact of inflation on consumption liability assumptions to our final verdict on whether factor investing is, in fact, worth your while.
Key Points From This Episode:
The latest phenomenon of people paying to go on popular podcasts. [0:01:58]
Interesting feedback we’ve received for our Crypto series. [0:03:49]
Why not to make an investment decision based on one person's opinion. [0:04:53]
The evaluation skills our Crypto series equips listeners with. [0:06:05]
Upcoming guests on the Rational Reminder Podcast! [0:07:31]
Some interesting LinkedIn connections we’ve made in the past few weeks. [0:16:06]
Recommended book for kids: Way of the Warrior Kid 3. [0:18:11]
Recommended book for adults: The Psychology of Money. [0:21:08]
The model of our firm’s book club and our experience of it so far. [0:22:02]
Does pooling finances result in greater relationship satisfaction? [0:24:35]
Liability duration and bond returns according to the current change in bond yields. [0:26:22]
How inflation impacts consumption liability assumptions. [0:29:11]
The positive effect the changes in the bond market have had on pension funds, relative to their liabilities. [0:30:20]
The main topic of the day: is factor investing worth it? [0:32:30]
The long-term volatility for factor-tilted portfolios. [0:33:56]
What factor investing is and the added risk it entails. [0:34:51]
A brief history of pricing models. [0:35:53]
A few characteristics associated with higher expected returns. [0:39:25]
The challenges of factor investing. [0:39:47]
How to determine the mix of factors that captures all relevant state variable sensitivities. [0:42:56]
The significance of size premium. [0:46:07]
Speculating whether factors deliver premiums. [0:47:57]
The steps involved in a hypothetical factor investment. [0:48:57]
A few important facts about factors. [0:53:23]
The benefits of having more independent risk premiums in a portfolio. [0:54:56]
Our verdict as to whether or not factor investing is worth it. [0:57:02]
Why it’s important to take tracking error into account. [0:57:38]
The tendency of factor-tilted portfolios to perform differently from the market. [0:57:48]
Read the Transcript:
Ben Felix: This is the Rational Reminder podcast, a weekly reality check on sensible investing and financial decision making from two Canadians. We are hosted by me, Benjamin Felix and Cameron Passmore, portfolio managers at PWL Capital.
Cameron Passmore: Welcome to episode 213 and you know what, Ben, you look at us wearing our hoodies. You'd think it's freezing outside, but it's in the mid 30s with humidity. It's so hot outside, I can't believe. I guess your air conditioning is really fired up.
Ben Felix: I haven't been outside today. I don't know.
Cameron Passmore: I just went out, it's really, really hot out. Anyway, it's off the top. We have a lot to cover today, but we wanted to give a shout out to our colleague, Melissa Larson. Melissa's a financial planning associate here at PWL and she received the top score for the May 2022 sitting of the QAFP exam, which is an amazing accomplishment. Heartfelt shout out to Melissa, congratulations. She was in a group of what, 185 other candidates, I believe, writing this four hour exam.
Ben Felix: Yeah, super cool. Very impressive.
Cameron Passmore: Also, wanted to give a quick note. I know a lot of advisors listen to this podcast. I'm heading off to the Future Proof Conference in Southern California in September. It's going to be a interesting conference. It's literally on the beach in Huntington Beach and a lot of really interesting people are going. So if you're going and you want to meet up, drop me note, feel free to email me or DM me on Twitter. Love to meet up. I mean, it's going to be funky, the guys at Ritholtz are behind this, so you know it's going to be a unique event. That should be fun.
Ben Felix: I will not be there.
Cameron Passmore: No, you're not so much on the traveling. You have a lot going on at home. I have a little bit more freedom than you do. I don't know about you, this is a separate note. Are you watching anything on any of the streaming services now?
Ben Felix: No.
Cameron Passmore: I haven't watched TV at all.
Ben Felix: That's more of a difference for you. I'm not usually watching.
Cameron Passmore: Well, you do. You and Susie watch stuff, but it's just so nice. I noticed I'm not watching anything, just reading and hanging around and traveling a bit. You wanted to talk about this story that a lot of people were retweeting yesterday about people paying to come on a popular podcast.
Ben Felix: Yeah, it was a story in Bloomberg. They had some examples of guests that had paid to appear on podcasts. And I think it goes the other way too. But the problem is this potentially undisclosed or lightly disclosed payment for appearing on podcasts, which is a problem for, I think obvious reasons. I just thought we would take a second to say that we have never accepted payment to have a guest on the podcast, we've never accepted an invitation from a PR company to host a guest and we get those frequently. Angelica probably sees them more often than we do, but sometimes they come to my personal PWL email. I think they probably usually go to the info@rationalreminder email, which we don't see.
Cameron Passmore: I get them on LinkedIn also.
Ben Felix: Yeah, so we get a lot of those, we've never accepted one and we've never paid a guest. We were asked once for payment. I obviously won't say who that was, but invited somebody and they said, "Sure, I'll do it for this amount of money." We said, "Nope."
Cameron Passmore: A very nominal amount, for the record, but we still didn't do it.
Ben Felix: Just on principle. If Gene Fama's going to come on our podcast and not want payment, then yeah.
Cameron Passmore: It's also worth noting too, that all the guests that we do have on come from our efforts and relationships, connections. That's part of the fun frankly, of doing this is the challenge of trying to identify interesting people and seeing if they'll come on with us. It is a really fun process and we don't hire any firm to search out people for us either, because that is a common service out there. They'll book the guests, find the guests. We don't do that, it's all you and I.
Ben Felix: Yeah, it's if we find an interesting book or I don't know. I don't even know how we think of people to invite on. Or we're chatting about something and we realize somebody would be interesting. But yeah, 100% our own effort and ideas and relationships, like you said.
Cameron Passmore: The crypto podcast.
Ben Felix: Yeah, as people who are listening to the crypto series know, we re-released the crypto portion of our episode with Cam Harvey that we had on the Rational Reminder, which as people have already probably heard me say, was what really led to the crypto series because Cam was so excited and we hold him in such a high regard based on his work in traditional finance. So we're like, "Okay, Cam's taking it seriously. We'll take it seriously too." Now we put that portion of the conversation back out there without any judgment. But the commentary that I gave was that it was a very different experience for me listening to it the second time around, after having done the previous eight episodes in the crypto series. We've learned a ton doing these crypto episodes and going back and hearing the conversation with Cam after that was a very different experience.
Now listeners agreed with that sentiment, but there were also some more harsh words for how people perceived the conversation when they were armed with the knowledge from episodes one through eight, which is interesting feedback to get. One listener, and this is a bit of an interesting little anecdote, they disclosed to the community that they bought into a recently released crypto themed ETF after listening to the episode with Cam. I looked back when we released that episode with Cam Harvey, Bitcoin was at $57,000 USD, close to the peak, not quite at the peak. That was on October 14, 2021.
Then after the Cam Harvey episode, before the crypto series, we released the episodes on thematic investing and then we released the crypto series and this listener is listening to all of this. They're telling their story of they heard the Cam Harvey episode, they invested in crypto and then heard the thematic investing episode and then heard the crypto series episodes. Of course, the whole time crypto's also tanking. But they told this story in the community because they wanted to share the lesson that they took away from it, which was never to make an investment decision based on one person's opinion. Even if they are incredibly tenured and wrote a fancy book about the topic. I just thought it was an interesting story. Didn't feel great to read because obviously we had Cam on the podcast, we hosted that conversation. But yeah, it was a real experience, so it was interesting to read about.
Cameron Passmore: It's also a testament too, to the first eight episodes.
Ben Felix: True.
Cameron Passmore: How it affected someone's thinking and view on the subject.
Ben Felix: Yeah, it shows that people who've been listening to the crypto series are much better equipped to evaluate enthusiastic views on crypto, which is what I think we got from Cam.
Cameron Passmore: I'd even make it broader than that. Really helps just to evaluate period. To do critical thinking, because this one does touch so many verticals and it is out of the traditional factor asset pricing models that we typically talk about. This goes into so many different things, which we said so many times and it really is mind expanding. And the more we learn, the more you get into philosophical topics, governance topics, societal, structural. It's been an unintended consequence that the whole thing is blowing my mind, not just the crypto part.
Ben Felix: Yeah, we recorded some episodes earlier this week that were all of the things that you just said. I think they got pretty deep into philosophy, sociology, all kinds of interesting areas. Then we actually say this, I think in the introduction to tomorrow's episode with Hillary Allen, that it's almost a shame to have this called a crypto series because crypto's the side show. Crypto's a reason for us to talk about a whole bunch of other really interesting topics that we just wouldn't have thought to talk about if it weren't for crypto. But in the end, like I said, crypto is the side show. We're having all these in interesting conversations that are tangentially related to at least the claims of crypto proponents.
Cameron Passmore: Exactly. Upcoming guest next week, Jay Van Bavel's here, the professor of psychology and neuroscience at NYU and co-author of the book, The Power of Us. In three weeks, super excited about this one, Gus Sauter is here. Former CIO of Vanguard.
Ben Felix: That's going to be good.
Cameron Passmore: Going to be really good.
Ben Felix: We haven't recorded that one yet, but we've done the questions and it's going to be really good.
Cameron Passmore: Yeah, his character was talked at length in Robin Wigglesworth's book, Trillions. Robin was our guest back in episode 184 and if you've not read the book Trillions, highly recommend it. Gus has a big part in there, early on at Vanguard, the whole ETF decision that they made. He was there from very little assets in indexing to what they became. Then two weeks after that, Colleen Ammerman is here, who is the director of gender initiatives at Harvard and co-author of the book, Glass Half Broken: Shattering the Barriers That Still Hold Women Back.
Ben Felix: Have you finished the book?
Cameron Passmore: I did.
Ben Felix: I'm not done yet, but I've almost finished. I think it's a very good book.
Cameron Passmore: It's very thought provoking, a lot of good points. Okay, based on our discussion two weeks ago about the reviews that were one star reviews, we pleasantly got inundated with reviews and we started a long time ago reading out the reviews. I think we have to keep the tradition up, Ben. But we got a lot, so I think we have to do these quickly.
Ben Felix: Yeah, let's try and do a speed round and if people want to skip ahead, I mean, now is the time to do it because I counted them, but so many have come in since I counted them, that I don't know how many there are. It's probably around 20 new reviews that came in.
Cameron Passmore: Yeah, and they're very, very kind and we really appreciate it. Maybe we can alternate, do you want to start and go through them?
Ben Felix: Okay, sure. Now these are all five star reviews except for one of them and we'll give some commentary around the four star review when we get there. "An excellent academically focused finance podcast, been a listener since the beginning and RR's helped me greatly in both my personal finance situations and my academic study in finance." Oh, that's nice, I hadn't read this one yet. "But Ben is better at explaining complex academic finance models than many of my professors. Hope you guys keep on doing the great work and don't let the recent trolls affect this great podcast."
Cameron Passmore: Another five star... "Best ROI from any podcast, helped me better understand the breadth, depth and uncertainty in the literature financial markets." Very nice, thanks so much for that.
Ben Felix: All right, "This podcast has transformed my financial life. Before my enlightenment, investments were based on the hottest stock tips from friends. This was stressful, I truly felt that more money meant more problems. Now I've got confidence, consistency, and most importantly, peace."
Cameron Passmore: Worth mentioning here that someone reached out to say, "How do you put a review on Spotify?" And I don't use Spotify, I use the Apple platform. Most these reviews come from the Apple platform, but some people did send in reviews directly, I think, to Angelica.
Ben Felix: Oh, so in the Rational Reminder community, a few people posted saying, "I listen on this," I don't even know. Some people listen on some privacy focused front end or some other tool that doesn't allow reviews, so they posted their reviews in the community.
Cameron Passmore: Another five star, "I enjoy the format, book reviews and the hosts conform to my favorite stereotype, Canadians are so nice."
Ben Felix: "Excellent, interesting, and thoughtful," from Richard. "I enjoy the breadth of information covered on personal finance, investing economics, behavioral biases, management, crypto, happiness, et cetera, all backed up by relevant research."
Cameron Passmore: Five stars from Sandra Holmes in Norway, "Best finance podcast available and it's not even close. Longtime listener from Norway, but an Australian expat. Just want to thank us for our hard work and quality content."
Ben Felix: Five stars from Dolfan and a bunch of numbers, "The best personal finance investing podcast out there. Most podcasts only superficially cover topics and are largely opinion based. This is the only one I've found that really dives into details and is evidence based."
Cameron Passmore: Five star from David F. in Canada, "Incredible podcast on finance and living a good life. I'm also encouraged to see Ben and Cameron explore topics on equality and stand up for their values. Through the podcast, I've learned how to be a better manager at work, a better role model for my kids and how to evaluate my life objectives and prioritize them. I'm calmer, more thoughtful, and I learned how to control my impulses." Very nice.
Ben Felix: Jeff 9999, "Consistently high quality investing content. The Rational Reminder podcast is my go-to for understanding the market. I have learned so much about economics, human behavior, stocks and bonds."
Cameron Passmore: Five stars from Makaveli86 in the States, "Great content. Don't listen to the haters. However, listened to the latest episode and hearing the few negative reviews being read out and I thought I should jump in," and we appreciate that.
Ben Felix: Yep, here's the four star review and I liked the reason for their four stars, actually. They say, "The podcast is lovely, hosts are charismatic. They know how to run an interview." Their only wish is that, "They made the show a bit more accessible for folks without prior investment experience. Seventy-five percent of what they talk about goes over my head." Impressive that you continue listening. We appreciate that. "For the hosts, is there a book I could read that would explain all the financial terms you use?"
I don't know the answer to the question, but I think if you're listening and you don't know a word or don't know what we're talking about, in the Rational Reminder community, if you want to go in there, if you ask questions, people are really, really good about answering. There's almost 7,500 people in there now, but it's a great community. It doesn't feel quite like the internet. It's very cozy and friendly. I think if you ask questions in there, if you're unsure about a term that we talked about, you will get a good answer if not from me, from somebody else.
Cameron Passmore: Next one, five stars from this is a great name, No Water Buffalo in Africa from the States, "Great podcast for the do-it-yourselfer who wants to broaden their understanding. I, for one, appreciate the breadth of topics discussed. Why have a voice box if you don't use it to raise awareness and drive discussion? As I assume you will read this to your audience, I will ride those coattails and give you my definition of success as I see it today. A healthy and happy family, a handful of close friends that I laugh with regularly, consistent focus on my good health, a decent work life balance with lots of time spent outdoors, and not too many regrets when I kick the bucket. Keep on trucking."
Ben Felix: Did they just backdoor into being an RR guest?
Cameron Passmore: I guess so.
Ben Felix: "Common sense investing in a growth mindset, solid reminders and lessons about the wealth building of low cost diversified index funds. It's about time personal finance folks grapple with the interpersonal and structural reality of money." We do appreciate these comments supporting a direction that we took for a couple of episodes that got a lot of negative feedback, but that's been corrected heavily by all of the positive feedback we got.
Cameron Passmore: Five star from Seth JD in Canada, "Outstanding from episode one. Ben and Cameron have grown alongside their listeners, providing extremely well researched and thoughtful conversations on personal finance. Especially love when something is 'not obvious' to Ben or when Cameron finds something 'phenomenal.'"
Ben Felix: Wagonomics says, "Great interviews. As a finance researcher, I enjoy hearing other researchers discuss their work. Favorites include Jay Ritter, Novy-Marx, Gene Fama, Cameron Frank, Lubos Pastor and Sebastian Betermier.
Cameron Passmore: The guest list really is crazy. Five stars from Dollar Ballers in Canada, "The podcast is a beacon of light in a sea of bad investing info. Here is an illustration of how much of an advocate I've become of PWL and their philosophy, thanks to the podcast. My employer has asked us to develop an investment strategy to invest a large sum of money into the markets. Those with more of a 'financial background' than me are advocating for an investment manager who prefers traditional stock picking and would invest the funds in about 30 or so stocks. On the other hand, I am gently nudging them towards an indexing approach and I've reached out to us to present the philosophy to my team. My colleagues were impressed and I certainly hope my employer will see the light when the two investing options are ultimately presented and end up choosing us or a like-minded manager. At least when the time comes to present the options, I will be armed with many of the facts that have been shared via this podcast. You guys are providing a public service," and they enjoy the podcast. That's pretty cool.
Ben Felix: Those situations are hard. I've done institutional pitches before. When you're up against an active manager with really, really shiny performance and small cap value have underperformed for the last 10 years, those don't tend to go well unless there's very strong adherence from the institution in terms of wanting this approach.
Cameron Passmore: Plus changing minds is very hard.
Ben Felix: That's what I'm saying. If an investment committee comes in and they've already made up their minds that they want our approach, done deal. If they haven't made up their mind, it's going to be a losing battle. That's true for individuals as much as it is for institutions. All right, the last one, the last review. "One of the best investing and financial podcasts out there. Backed by thorough research, academic findings, as opposed to so many, what I think is true or opinion based podcasts."
Cameron Passmore: Agree.
Ben Felix: All right, we did it. Thank you to everyone that wrote those many, many reviews. That was a mean reversion, I guess. I don't know from...
Cameron Passmore: All right, some cool contacts I had this past couple weeks on LinkedIn. Get this, Adam reached out on LinkedIn to congratulate Melissa. He saw that posting put out there and thanked us for the content. He's an advisor at a large firm here in Canada. Aaron, a listener from Ohio asked if we've considered having someone from Avantis on, which I think we have, you've talked to them.
Ben Felix: We will. We'll do it eventually, to answer Aaron's question. I know they are eager to have Eduardo on and we'll do it eventually. We've just been booked.
Cameron Passmore: Get this one, Ben. Steve from Calgary thanked me for the push for him to travel to Ireland next month. I gave him some, for what they're worth, tips on the west coast, which I think he's more interested in. I'd love to hear how the trip goes. Stan, who has an advisory firm in Greenwich, Connecticut reached out. Riley from Toronto said we've helped him immensely to stick with his index portfolio while his friends, "rave about crypto and hot new stocks." Lucas from Stockholm felt the negative recent reviews were unfair and is pleased that we stood by our conversation with Rebecca Walker. Chris reached out to get details on how to start a podcast. We're actually talking in a couple of weeks, so happy to help out in any small way I can.
Get this one about the reading challenge. Florian from, where is he from? I'm not sure where he is from. Somewhere in Europe, I believe. But he reached out to thank us for the inspiration for the reading challenge. He's now been reading for 100 consecutive days and he just finished a book, which I can't pronounce it and it hasn't translated into English yet, but very happy for the inspiration. Lastly, did you know that you're an emoji on Finanzfluss, which is Germany's biggest finance discourt with 30,000 users?
Ben Felix: I've been an emoji in other places too.
Cameron Passmore: Apparently this person used it in a dividend context. It's pretty funny. You've been emoji-ized. Anyways, that's it for the intro I think. As always, connect with us on Twitter, LinkedIn, YouTube, Ben's channel on YouTube as well. Don't forget Rational Reminder on Instagram. Then CP313 or #Rational Reminder on Peloton. Anything else, Ben?
Ben Felix: No, let's go ahead. Welcome to episode 213 of the Rational Reminder podcast.
Cameron Passmore: Okay, we're going to try something different this week and see how it goes. I forget where this idea came from. I believe it was someone on one of the platforms suggested this, so I said, "Oh, why not? We'll try it." We have a number of obviously listeners who have kids and are often looking for ways to inspire kids to read something. This is a book that was recommended, that is directed at kids age eight to 12 and it's called Way of The Warrior Kid 3 by Jocko Willink, and it's illustrated by Jon Bozak. I had not heard of this series before, but it's a popular series and also, I think there's a podcast with it. It's written by Jocko Willink. Many of you have probably heard of him. He's a popular author, but he's also a retired, highly decorated Navy Seal. This book basically takes what he learned about discipline, hard work, self-confidence and wrap these messages up in a book targeting eight to 12 year olds.
He's also very well known for the book, Extreme Ownership, which is an extremely popular book on leadership and I'm sure many, many listeners have listened to. Anyway, Jocko wrote this book targeting younger kids, and it's a story of a kid named Mark who learns lessons from his Uncle Jake. Lessons such as learning to be uncomfortable can make you stronger, pushing yourself out of your comfort zone. Really interesting part of the story talks about ego, which is something we've talked about here with the book, Humbitious, for example. A person shouldn't think that they're the best in the world, but they shouldn't think they're the worst either, is the message in the book. And you shouldn't be jealous about someone who you might perceive as better than you at something. Anyways, it's a book chockfull of lessons, covers on some financial lessons as well. Life isn't all about money. Money isn't the only problem people have and money doesn't solve every hardship. Also, gets into physical fitness lessons inside the story.
And in the end, it comes down to what he calls warrior kid rules. There's nine rules, I'll read them quickly. I think if you find the rules part of your value set, I think this book is worth to your son or daughter. Number one, the warrior kid wakes up early in the morning. Number two, the warrior kid studies to learn and gain knowledge and asks questions if he doesn't understand. The warrior kid trains hard, exercises and eats right to be strong and fast and healthy. The warrior kid trains to know how to fight so you stand up to bullies to protect the weak. I'm not so sure about the fighting part, we'll let you pass your own judgment on that. The warrior kid treats people with respect and helps out the other people whenever possible. The warrior kid keeps things neat and is always prepared and ready for action. The warrior kid stays humble and stays calm. Warrior kids do not lose their tempers. They work hard, save money, are frugal and don't waste things. Always does their best and I'm the warrior kid and I'm a leader.
Bottom line, I enjoyed it, I think the messages are solid. If you have an eight or 12 year old, I think this book is worth passing on. Speaking of passing on, a number of people have asked, "What's a book I should consider reading this summer?" So we've covered a lot of great books, we have 22 suggested books on our website. But the book I get the most unsolicited positive feedback on is Morgan's book, The Psychology of Money.
Ben Felix: Me too.
Cameron Passmore: Out of the blue people will ask, "Have you read this book?"
Ben Felix: I know. The same thing happens to me. It's a super popular book and it is a good book. I always find it funny though when I get that question, because obviously interviewed him about it.
Cameron Passmore: Yeah. I mean, exactly. But somehow it's almost like it's reached the tipping point where a lot of people are just recommending it in general. I thought I'd pass that along. If you haven't read it, it's a phenomenal book. I think it just passed two million copies. I think he had a stack on his Twitter feed this week, 49 languages, I think it's been translated into. A huge stack of books been translated.
While we're on the topic of reading, I wanted very quickly pass this idea along. I'd never heard of it so I thought might help you in your own organization. Everyone knows we do a lot of reading around here and many of the books that we talk about help individuals and also help organizations. The most recent book's The Fearless Organization, we talked about and Deep Work are pretty good examples of that. Anyways, a couple months ago I was talking shop with our very good friend, Larry Swedroe, and he suggested, he said, "You know what? You guys might want to do what we're doing, which is we have a book club." I'm like, "That's a cool idea." We hadn't thought of it before.
So we, being a small, arguably nimble firm, we got one going right away. We've already had two book club sessions and they're phenomenal. I just thought I'd share with you the model that we're doing in our company and the experience so far. What we've done is we meet monthly, set it up for one and a half hours. Typically, the last Friday of the month is what we're going to try to do. Attendance is totally optional. We've had 15 to 20 people at each of the first two. Different people, not necessarily the same people at both of them. We set a schedule of books for the next six months so people can see what books are coming up. Depending on what pace you read or what books might interest you, you can prepare to come to that session. Every month we add a new book so we're always six months looking forward.
We have a little voting mechanism to pick what the next book would be. The only rule in this club, is that the book must be about either improving us as individuals or the business. We welcome observers, so if you've not read the book, you're more than welcome to come and observe. Each book is led by two volunteers. The first book we did was The Infinite Game, by Simon Sinek and then the book we did last week was Humbitious by Amer Kaissi. We ask for someone to scribe the meeting and write the summary notes, which have been excellent. It's really cool to see how different people take away different messages and interpretations from the book and then apply to our environment.
We've had some really great discussions about applying lessons from the book. It's been a total blast. Another rule we have is that it's got to be fun, it's lighthearted. We're title or ranked blind in this meeting. It's also really fun. Last week, Sandrine, which people have heard us talk about Sandrine before on our marketing team, she led the discussion last week and put a lot of thought into understanding the book and posing really interesting questions and keep the discussion going. Shout out to Sandrine for leading that. And thanks to Larry. Larry's got a lot of great ideas. In your organization, if your culture is open to this, I highly recommend it. We love it so far.
Ben Felix: Awesome.
Cameron Passmore: Okay, onto the meat of the podcast.
Ben Felix: Yep. There's a paper that somebody posted in the Rational Reminder community that I thought was interesting enough to mention, Pooling Finances and Relationship Satisfaction. It was in the Journal of Personality and Social Psychology. In the paper, the authors predict that couples who pool all their money, compared to couples who keep all or some of their money separate, experience greater relationship satisfaction. And the basis of the prediction is interdependence theory, which I will not define. You can read the paper. Oh, maybe I will define it, sorry. The theory argues that relationships are defined through interpersonal interdependence, the process by which interacting people influence one another's experiences. They go through a much deeper definition in the paper.
Cameron Passmore: Oh, it's a serious paper.
Ben Felix: Yeah. I won't go into that, but there's the light version there. That's the prediction. They demonstrate across six studies that couples who pool all their money, again, compared to couples who keep all or some of their money separate, experience greater relationship satisfaction, feel more committed to their relationship and are less likely to break up. The effect is particularly strong among couples with scarce financial resources, like those with low household income or those who report feeling financially stressed. It's just interesting.
Cameron Passmore: It's really interesting because this is a question that I used to get quite often as couples got together. Like, "Should we pool our money or not?" So many people have very strong opinions on both sides of that, but now we have a little bit of science to back up what the answer might be.
Ben Felix: Exactly, because I agree. I used to get this question a ton. I don't know why.
Cameron Passmore: Did this paper change your opinion?
Ben Felix: Well, one of the takeaways from the paper is that the effect is strongest for couples who have scarce financial resources. Which the reality is, are not the households that we tend to be giving advice to. I think having this information as part of the conversational toolkit, if people ask that question is useful.
Cameron Passmore: Fascinating.
Ben Felix: Then I just wanted to talk about liability duration and bond returns. We updated our financial planning assumptions as of June, with June data and 75% of our estimate for fixed income expected returns comes from bond yields. And bond yields jumped a lot from December 2021 to June 2022. So our expected return for fixed income went from 2.48% nominal in December to 3.91% nominal now. Big difference. But we followed our process. It's a formula that we developed for the income methodology we developed for expected returns. We did the calculations, put it out there for our advice team and as they started meeting clients and updating financial plans, we got a lot of questions like, "Financial plans have gotten so much better. What happened? Are you sure the numbers are right?" And the reason is because of the difference in duration between fixed income assets and most of our clients' consumption liabilities.
I'll explain what that means. The future consumption liability, it's the cash flows required to fund your future consumption. If you think about that like a bond, it's a liability to you, that'll tend to have more payments in it than the average bond in a aggregate bond index. Because of that, the present value of the consumption liability is going to be a lot more sensitive to interest rates than an aggregate bond index. If you own a long duration bond, it might be more similar to your consumption liability, but an aggregate bond will tend to be shorter, like XBB has a duration of 7.67 years. The dimensional fixed income that we use in client portfolios has a duration of four years.
Cameron Passmore: Right, currently.
Ben Felix: Yeah, currently, or at least last time the data was updated probably in June. Now XBB is down about 9% year to date. I ran just rough numbers in Excel, but I took the present value of a hypothetical 60 year cash flow stream, that's the consumption liability, based on the change in yields, that liability has decreased by about 25% year to date just based on the December to June change in yields. Again, if consumption liabilities have longer duration than your bond portfolio, then they're going to be more sensitive to yield changes. Even though bonds have taken a hit and people are worried about, oh, the bond market prices fell. Well, yields went up and as long as you have liabilities with longer duration than the bonds that you held, you're actually in a net positive position, which is interesting.
Cameron Passmore: How does inflation impact that?
Ben Felix: Yeah, great question. We use in our estimates for inflation, three inputs. None of which have changed very much, despite realized inflation being very high. The biggest input that would change our estimate would be well, if the Bank of Canada changed their target rate. Historical inflation's not going to change much, which is the other input. Then the break even rate, the inflation rate that the bond market is pricing in, that's the biggest one that we would expect to swing and affect our assumption. But it's been pretty much constant.
Cameron Passmore: That's incredible.
Ben Felix: Yeah. So the market's not pricing into 30 year government and Canada bonds. The market's not pricing in current realized inflation. It is pricing in 1.8% as 30 year inflation as the bond market's basically saying it's not worried about realized inflation being high. If the bond market starts pricing in realized inflation, and that becomes expected inflation, then things would change.
Cameron Passmore: That'll change your 25% number dramatically.
Ben Felix: The XBB number would change too. We'll see if that happens. Now, the other place that this shows up, and this is one of the things that I tried to use when we were talking to our advisors about this and helping them think about how to communicate this to clients, is that pension funds have also been positively affected by these changes in the bond market relative to their liabilities. The funded status of a bunch of Canadian pension plans, and there's a couple different ways to get that data. There's actually an article about it in the Globe and Mail that summarized a bunch of it. But the funded status has jumped from below 100% in a couple different data sets at the end of 2020, to now well above 100% funded status in June 2022. Again, similar thing. The present value of liabilities dropped like a rock.
Cameron Passmore: That's really interesting, that relationship, to think about that. Even though your bonds may be down, your liabilities are down significantly more.
Ben Felix: Yeah. I think as long as you have liabilities that are of longer duration than your bond portfolio, the rate increases have been a net positive. If you had a bond duration that exactly matched the duration of your liabilities, then you would be asset liability matched and you'd be immunized against changes in rates. But as long as your liabilities have longer duration than your assets, you're positively affected by rate increases because your liabilities are more sensitive to the rate change.
Cameron Passmore: Very cool.
Ben Felix: But it's a big difference. I mean, it's kind of scary, honestly, from a financial planning perspective because of course, it could change again. But it's materially changed the advice that we would give to clients now, relative to what we would've given based on the previous assumptions, just in terms of how much you need to save or how much you can spend and all that kind of stuff.
Cameron Passmore: Especially with the backdrop of the narrative of the first six months of this year.
Ben Felix: What? Just things are bad?
Cameron Passmore: Things are bad. I know there's always things that are bad, but there's a lot more talk of high inflation, the war, all kinds of stuff going on in the world.
Ben Felix: Yep. Rising rates, net positive for long term investors, which is something that I knew, but plugging the numbers into financial planning software and seeing how dramatic the effect is on financial plans, on people's projected ability to fund their future consumption, it's pretty staggering.
Cameron Passmore: Awesome. Okay, and the main topic.
Ben Felix: Yeah, is factor investing worth it? Lots of people will probably be interested to know the answer to that question. I don't know if I actually have an answer, but we'll do our best.
Cameron Passmore: You got to set this up. Where did this one come from?
Ben Felix: Oh, sure. Something that we've been working on for a while, is developing a methodology that we're comfortable with to have expected factor premiums in our expected return assumptions for equities. Yeah, we did lot of work on that and we arrived at a methodology that we're comfortable with, so we have a number for what additional net of fee expected return we have for the dimensional portfolios that we use for clients, but we can apply the same methodology to other funds too. I think it just gives a quantitative input to that question of, is factor investing worth it?
Of course, there are lots of other inputs and we'll talk a little bit about some of those. But in terms of, is it worth it after costs in terms of expected returns, we have a number for that now, and it's low. I mean, lower than what AQR uses. One percent, I believe as a premium for a long only multifactor portfolio. Dimson, Marsh and Staunton I think, have used of something similar maybe. One percent, I think I read in one of their past reports for a long only size and value I think, tilted portfolio. The estimate we have is below that, so I think it's pretty conservative. Does that answer the question?
Cameron Passmore: You going to talk about impact on volatility also?
Ben Felix: I didn't include that in here. Long term volatility for a factor tilted portfolio has been very similar to a market cap weighted portfolio. The last five years, a factor tilted, like a size and value tilted portfolio has been much more volatile than a market cap weighted portfolio. But in the long term data, they're within basis points. I don't really know if there's a good answer to that question, if a factor tilted portfolio is more volatile. It has been more volatile in the last five years. Should we expect it to be more volatile in the long run? I don't know. I don't know if there's a easy way to answer that question. Because you got to remember too, that if we're talking about standard deviation, other than maybe small caps, factor tilting shouldn't necessarily increase standard deviation.
Cameron Passmore: This is about is it worth it for higher expected returns?
Ben Felix: Well, higher expected returns, but we're going to talk about the risks that are not standard deviation and how to consider those.
Cameron Passmore: All right.
Ben Felix: Okay. Factor investing, as many listeners would already know, is the idea that portfolios can systematically capture higher expected returns by emphasizing certain types of securities. Traditional index investors simply hold the stocks at their market capitalization weights. So whatever weight they make up of the market in its natural state, you hold that in your portfolio. Whereas a factor investor uses the information in prices to over and underweight stocks based on their expected returns. As an example, a factor investor might hold lower priced stocks, value stocks at a higher weight than they exist in a market cap weighted index fund. That's the systematic overweight to value stocks in that example.
Now factor investing makes a lot of sense, both theoretically and empirically, but it does have slightly higher costs, it does have added risk. At least if you believe in the risk based theory. And it has tracking error, so performance that's different from the market, which can be psychologically challenging. We've got an interesting data point on that, that I'll talk about later. Okay, on the theory side, and this is maybe a bit of a review because we covered something similar not too long ago, but the capital asset pricing model is a single period model that relates differences and expected returns to differences in exposure to market risk or beta. CAPM investors want to optimize the mean and variance of their portfolios. In a CAPM world, all differences in expected returns are explained by beta.
Now, empirically we do not live in a CAPM world. Throughout the 1970s and beyond, up until probably yesterday, tests of the CAPM which are jointly tested market efficiency, have found that the CAPM fails to explain the returns of certain types of stocks. That was low beta, I think was the first anomaly. Size, value, then of course, the many hundreds of other anomalies that have been uncovered since then. The CAPM failing can either mean that the market's not efficient, as some early papers argued, or that the CAPM is just missing something. It's not capturing some other things that investors might care about.
That brings us to the 1973, Robert Merton ICAPM, the Intertemporal Capital Asset Pricing Model. In the ICAPM, investors don't only care about the mean and variance of their portfolios. This is my comment earlier, Cameron, about we're not necessarily talking about a more volatile portfolio. ICAPM investors are multi period investors, which is why it's the intertemporal model. In addition to mean and variance, ICAPM investors are concerned with the co-variances of their portfolio returns with other things like labor income, the prices of consumption goods and the nature of their future investment opportunities and how that all relates to other aspects of their economic life.
You can see there, I mean, we could think of a hypothetical example where two portfolios have the same variance, but a different co-variance with some other thing like labor income or discount rates, I don't know. And one of those portfolios would be riskier than the other for some investors, I guess. Same variance, it's not necessarily a higher standard deviation story. To reiterate that in slightly different words, in addition to the variance of returns, ICAPM investors also care about when the variance shows up in relation to other aspects of their lives and how it's related to future expected returns. Now the ICAPM, unfortunately be nice if it did, but it does not specify the state variables that investors are concerned about. But this is of course, where we arrive at Fama and French's cross section of expected returns work that finds other characteristics that may proxy for the unknown risks in the theoretical ICAPM model.
Now, the alternative explanation for the CAPM failing is that markets are inefficient. The prices deviate from their CAPM predictions because investors make persistent behavioral errors, resulting in mis-priced securities. That gets pretty interesting too, because if we say, "Hey, the market's not ICAPM efficient, it's CAPM inefficient," I guess, then you're not taking any additional risk by tilting toward characteristics that have historically had higher returns. You're exploiting the behavioral errors of other investors. But even then, I mean, we talked to Hersh Shefrin about this, and he talked about sentiment risk. There's still a risk in there because well, it's maybe the old saying of markets can stay irrational longer than you can stay solvent. I think that's the kind of sentiment risk he was talking about.
Now, theory aside, regardless of the theoretical position you want to take on ICAPM versus behavioral mis-pricing, we do have an empirical reality that certain characteristics like company size, relative price, profitability, and momentum are related to higher returns in the data. Can't argue about that part. We can argue about why that's true. We can't argue about the fact that it is true. Now, one of the problems for factor investing is that while I just rattled off a few characteristics that are associated with higher expected returns in the data, there are literally hundreds of documented factors. This is of course, what John Cochrane called the factor zoo. I think there is a valid question of whether this is all just data mining. We've talked about this paper before, 2021 paper, Is There a Replication Crisis in Finance? That paper looked at 153 factors across 93 countries using a Bayesian framework.
It starts off with the prior belief that factors have zero expected return and allows the in sample results to incrementally increase the estimated premium. The authors find that the majority of factors in their sample can be replicated in sample. They can be organized into 13 themes. They work out of sample and their strengthened, not weakened by the large number of observed factors. They additionally show that some out of sample factor decay should be expected in light of Bayesian posteriors based on published evidence. That point I find fascinating. They're basically saying that starting from the prior belief that a factor premium is not different from zero, a published observation strong enough to update the belief may be partially due to luck, in which case some of the out of sample premiums should be expected to decay. It's like at the time that these things get discovered, there's a pretty good chance that they had recently had a good run, which is why they got discovered.
Even if it is theoretically there for a good reason at the time of discovery, there's a good chance that it was higher than it's whatever natural state, if we can call it that. So you should expect lower premiums. And we use the approach they develop in their paper to temper our expectations based on the historical data. But we'll talk more about that in a sec.
Then there's a 2015 paper, Does Academic Research Destroy Stock Return Predictability?, because that's another interesting question. Data mining aside, even if these anomalies are real, do they go away once they have been discovered because they get arbitraged away? This paper looks at the out of sample post publication return predictability of 97 variables shown to predict cross sectional stock returns. And they estimate that returns are 32% lower from publication informed trading. The premiums don't go away, but they are about 32% lower out of sample after publication. That's another interesting data point that actually the previous paper, Is There a Replication Crisis in Finance?, I think they find about a 30% decline using their framework, which is pretty close in line with the 32% here. That's what we use. We use a 30% haircut relative to historical premiums as an estimate for future premiums. Even after that haircut, they're still meaningful as we'll get to in a second.
One of the other challenges is given factors are real, that it's not just data mining, how do you pick which factors you want to tilt toward? Because I mean, if there are hundreds of factors, there are many competing factor models, every researcher is going to tell you all of the many good reasons that their factor model is the best one. I mean, what do you do with that? It's not super obvious.
Cameron Passmore: Which one, how much?
Ben Felix: Yeah, exactly. One approach to determining the mix of factors that captures all relevant state variable sensitivities, is using the maximum squared sharp ratio criterion, which is developed in the 2016 paper, Which Alpha? If some combination of a model's factors or ex post mean variance efficient, then no other asset can be used to improve performance and the model prices everything. I think this gets back to what we talked about in our modern, modern portfolio theory episode about how the market portfolio cannot be mean variance efficient. It's multifactor efficient, but if it's multifactor efficient, it cannot also be mean variance efficient, which means that the mean variance optimal portfolio must tilt toward factors. I think this methodology that they developed in this paper is getting at the same idea, but I don't have enough PhDs to know for sure. But I'm pretty sure.
In the 2018 paper, Choosing Factors, Fama and French apply this maximum squared sharp ratio test for six possible factor models and they find that a model including the market risk factor, size, value, profitability, investment, and momentum performs well in all tests. They took the 2016, which alpha methodology, used it to look a bunch of different models and they find that the Fama, French six factor model, which is their five factor model plus momentum, is the one that looks the best.
But then there's a 2021 paper, Model Comparison with Transaction Costs, where it's a Novy-Marx paper with a coauthor, they find that when transaction costs are accounted for, momentum detracts from the model's performance. If we follow the narrow line of papers that I just talked about, that brings us to the Fama, French five factor model as still being the one that's closest to ex post mean variance efficient. The factors in that model are the closest to being ex post mean variance efficient when we account for transaction costs.
Now, of course, we've got to be clear here that there is no objective truth. We didn't just discover the law of gravity. A little different, but I do think that the factors in the Fama, French five factor model are at least a good place to start thinking about which directions it might make sense to tilt a portfolio. There's other stuff in there too, like from the perspective of actual portfolio implementation, Gerard O'Reilly gave us lots of information when we talked to him about why these factors are useful from a portfolio implementation perspective, because they also tend to be very low turnover factors. But anyway, we'll take it as a given for a minute that the Fama, French five factor model prices everything.
Okay, so from here, we've chosen a model. We've got the Fama, French five factor model. Determining whether tilting toward those factors is worthwhile still requires making some assumptions. So we looked at historical premiums as a starting point from July 1992 through May 2022. The world equity risk premium was about 5.5%, the size premium was 0.36% and the not statistically significant value premium, 3.07%, profitability, 3.91% and investment 2.65%. Now people will have probably noticed and I also gave a comment about it, that the size premium was pretty small over this period. Statistically, interestingly, it's been indistinguishable from the zero since 1981, when it was first published by Ralph Bonds. Now, that's interesting and people have called for the death of the size premium and stuff like that, which is always an interesting debate to talk about.
Cameron Passmore: Remember asking Cliff Asness that question.
Ben Felix: Yeah, and he explained that it's just a high beta phenomenon, unless you control your junk, which we'll talk about briefly here. If you take out small cap growth, low profitability and small cap, high asset growth stocks, which are just terrible in the data, if you take them out of the small cap universe, the size premium does become statistically significant again. That's about 15% of small cap stocks that you have to eliminate to get there, so you can do that. It's that thing that's similar to Cliff Asness' 2018 paper with coauthors, Size Matters if You Control Your Junk. Same idea, their title was good.
Cameron Passmore: They're always good. We actually talked about that on a podcast, how they come up with their titles and they're really deliberate about edgy titles.
Ben Felix: Oh, you can tell, you can tell. Yeah, the size premium is still there if you take out the junk, then it becomes statistically significant again. Then the other important point there on size is that there are powerful interaction effects between size and other factors. There's a 2021 paper called, Settling the Size Matter, that we've also talked about, I think that goes into that. On size, a bit of a size digression, I guess even if the standalone premium for small cap stocks is small, like the unfiltered small cap premium, when other known factors are applied within small caps, small caps can start to look pretty good and other factors can start to look better within small caps.
Another point that's worth just mentioning is that a lot of people have a perception that factors have not delivered premiums since they were published in Fama and French's 1992 paper on the cross section of stock returns. Fama and French actually find in their 2020 paper on the value premium that it is, in the US at least, much weaker out of sample. Although in that paper they cannot statistically determine if the out of sample premium is different from the in sample premium. Bit of a brand twister, I guess. Now, while that's true for the US evidence, it is weak for value out of sample in international developed and emerging markets, the value premium has actually been quite robust since 1992, which does show up in the premiums that we're using for our estimates here, because we're using a world factor premium, which of course includes international developed and emerging markets.
The post July 1992 sample that we're using is also out of sample with respect to the initial publication of Fama and French's paper, which had size and value. We're using out of sample data, maybe not for profitability and investment, I guess, but the main drivers in terms of the loadings, at least in the funds that we're going to talk about, are size and value. This is out of sample, but we're still going to apply 30% reduction to the historical out of sample premiums to be extra conservative. Because we could have said, "Hey, this is out of sample. If there's any luck or whatever, it's dissipated. And if there's any arbitrage that had to happen, it's happened."
Cameron Passmore: This is quite a buildup.
Ben Felix: We're still going to give the 30% haircut.
Cameron Passmore: The drama is palpable here.
Ben Felix: Okay. Then the next step, we have premiums. I guess I haven't said what they are, but maybe it's not relevant to go through what each... Oh no, we talked about the historical premiums and then we apply a 30% haircut. We have those, we call it a shrinkage factor. We have the shrunken premiums. Now we've got to understand how much of each premium of fund can be expected to capture. We do that with a five factor regression, which is a statistical method to determine the sensitivity of a portfolio to the factors in a model. A sensitivity of one in the regression indicates that if a factor returns 5% over the time period, then the portfolio will similarly see a 5% contribution to its return from that factor loading. In long only portfolios generally, which don't take short positions, you're going to see factor loadings that are below one, except for the market risk premium, which is often going to be close to one in diversified portfolios.
The regression can be done in Excel, which is what we do for Canadian data, because it's not in online tools like Portfolio Visualizer, which can also be used to do the analysis. Applying this to a fund is where we get the rough estimate of the difference in expected returns between that fund and a market cap weighted portfolio that only offers exposure to the market risk premium. Take the loading, multiply them by the premiums after the shrinkage factor and that gives you a very, very rough and probably noisy estimate of the added expected return in excess of market.
As an example, I just threw the Avantis US equity ETF into Portfolio Visualizer. It's a US total market equity fund that tilts towards smaller, lower priced and more profitable companies. Applying the factor loadings that I get from the regression in Portfolio Visualizer and the shrunken historical factor premiums, I get an expected excess return of about 50 basis points before costs. Now, the other thing to consider I mentioned at the very beginning of this segment, that factor funds, factor products are going to tend to have higher fees than market cap weighted products. AVUS has an expense ratio of 0.15%, but you could alternatively buy ITOT, US total market index from BlackRock that has a fee of 0.03%. Now we could get into more details, like what are the differences in securities lending revenue and stuff like that. We're not going to go that detailed right now. Although, that data can be an interesting input, especially because SEC lending revenue can be higher for smaller cap companies.
But anyway, we'll leave it at that expense ratio for now. The difference in fees, 12 basis points, take that off of the 50 basis point excess expected return that we found and that's a 0.38% net of fee expected return difference between AVUS and ITOT. So 38 basis points, there you go. Of course, more aggressive tilts are going to tend to have higher expected returns and higher fees and costs. Thirty-eight basis points compounded over a long period of time is pretty meaningful. I applied the same methodology to the Dimensional Fund Advisors' global equity fund that we use in our client portfolios. It's globally diversified, it's also got slightly more aggressive tilts than AVUS. The costs for international portfolios also tend to be a bit higher. You take all that together and I find an estimated premium of 45 basis points compared to a geographically comparable portfolio of market cap weighted Canadian index funds. So 45 basis points is the excess expected return net of fees for that dimensional portfolio.
You can do this for anything, for any security, especially for US ETFs that are easy to throw into Portfolio Visualizer. It's a pretty quick process really. But beyond the rough premium, I think it's important to understand a few things about factors. They're not guaranteed to pay off over any time period, as anybody in value for the last decade or so, except for the last few months, I guess knows. There can be long droughts of zero or negative premium. Now, again, that can happen for the market, the equity risk premium just as it can happen for the other factor risk premiums. But who did we talk to that about? It's more painful for people to go through periods of pain with factors than it is for the market portfolio. Is that Cliff we talked to that about? Somebody, maybe it was Rob Arnott, somebody that's in the asset management business. They'll stick with equities through periods of low returns longer than they'll stick with factors.
Now, the other big thing to understand is that at least if you believe the ICAPM theory, the premiums exist because a lot of people don't want to own these stocks, that's why they exist. I think before anybody pursues a factor investing strategy, you've got to ask yourself if you're one of those people, which it's a big question. I don't know if I have the answer, at least not for everybody individually.
Cameron Passmore: But the same goes again for market.
Ben Felix: Yeah. Well, the market is multifactor efficient. The market has the right exposures for the average investor. The market, of course being not 100% stocks either. It's whatever, 50/50 or 40/60 or 60/40 or something. But that portfolio is the theoretically multifactor efficient perfect basically portfolio for the average investor. Now, are you the average investor? Good question. That's also hard to determine. I would tend to argue that having more independent risk premiums in a portfolio is good because it increases the reliability of the long term outcome. If you bet on a single risk premium, like the equity risk premium, if it fails to deliver over your investment lifetime, I mean, you're out of luck. Global diversification maybe helps a little bit with that, but not necessarily completely. In a recent episode, we talked about a whole bunch of different examples of countries that have had equities trail bonds, not necessarily trail bills, but trail bonds for very extended periods of time, while contemporaneously value stocks outperformed the market.
It's a possibility, it's not a thing that I'm just saying can happen. It's a thing that has happened. It's happened in the US, it's happened in Japan. In Japan, it's really still happening. Yeah, it can go the other way too, where again, like we've seen more recently where the equity risk premiums ridiculously positive while value suffers for extended periods of time.
Although another interesting input, I think, to this whole is it worth it question, is the Fama, French 2018 paper, Volatility Lessons. They use bootstrap to create a whole bunch of hypothetical outcomes using historical data. Bootstrap is random sampling with replacement. They used US data from July 1963 through December 2016 and they find that over 10 year periods, they looked at longer periods too, but 10 years just seemed to be the most interesting. They looked at 10 year periods, there's an approximately 16% chance of a negative equity risk premium, where there's only a 5% chance of small cap value stocks underperforming the market over that same 10 year horizon. Just an interesting data point.
The 2017 paper, A Wealth Management Perspective on Factor Premium and the Value of Downside Protection finds that even when factor premium mean expected returns are reduced by 50%, which is notably more than the 30% reduction we gave them, they provide substantial benefits from the perspective of narrowing the distribution of wealth outcomes. That's again, evidence suggesting that factor risk premiums are not only useful for increasing expected returns, but also for increasing the reliability of outcomes, which again comes down to different performance at different times. Whether factor investing is worth it, it's ultimately a subjective decision, of course.
The fees and costs to obtain factor exposures have fallen a lot in recent history as more well-constructed products have become available from multiple providers. It's still not for everyone. By definition, it can't be or it wouldn't be a thing. There have to be either behavioral errors that people are making or risks that people don't want to take for the premiums to exist. You got to make sure you're not one of the people that shouldn't be owning the stocks. You don't want to end up being one of the people that results in the premium that somebody else captures. Then I think that the tracking error piece, I don't know if it gets enough credit because people think, "Oh, tracking error. I can handle that. That's not a real risk."
Cameron Passmore: They want the positive tracking error, that's why.
Ben Felix: Yeah, right. Factor tilted portfolios are going to perform differently from the market. Like you said, that's nice when the market is doing poorly and factors are delivering positive returns, which is what we saw in the decade from 2000-2010, it was like value in small cap value in the US, they did great, market was terrible. It's like, "Awesome! Factor investing's great."
Cameron Passmore: Total contrast to the late '90s. Which was all first time...
Ben Felix: Or more recently. The 2010s were also brutal for factor investing. With that, the 2010s, we're talking about a decade, still a tracking error, whatever. No, it can be painful for a very long period of time and you're paying higher fees and you know you're taking additional risks. And you're being told that there's a structural change happening that resulted in the premiums going away, which by the way, just means you don't expect excess positive returns. You don't necessarily expect guaranteed negative returns if the premium goes away. It's just a random walk around the equity risk premium at that point.
Now this is the point that I think is really interesting. I remember when I started working at PWL and learning about Dimensional, one of the things that was interesting about them is that they'd been around since the early 1980s. At this time, whenever I started at PWL, 2013 I guess, they had seen positive inflows into their funds, net inflows into their funds every single year since inception. And that was true until 2020, which March 2020 was the depth of the value drawdown. It was brutal. We talked about it on the podcast, you saw the data. It's literally the worst period for value ever. It wasn't like it just happened quickly. It was like this was the end of a multi-year period of under performance that just kept getting worse and worse. In that year, in 2020, they saw net outflows for the first time ever. And 2021, some small outflows, not as big as 2020, but still some outflows.
Now after that, April 2020 value came back, as we all know now. Dimensional's value tilted funds outperformed the market by a wide margin, wide. I think it was almost 500 basis points when I looked, annualized from April 2020 until I guess, June or July 2022. I can't remember what I looked at, but it was big, huge. The point of the little story is that the investors who bailed at that time lost out on the premium, but that's a real risk. And clearly as we can see from the flows data, some people ate that risk. That's when we say tracking error matters, I mean, it does. I think that's one of the considerations. I didn't answer the question of the segment, is factor investing worth it? I don't know. I think so, but it's not right for everybody. Again, by definition, it can't be. What do you think?
Cameron Passmore: I think you're right. You always have to think about how are you different from the market. But the one that jumps out at me is it's great for increasing the reliability of outcomes. That is pretty compelling when you have serious money, with serious life plans, that's what you really want. Many people really want that.
Ben Felix: Yep. I don't remember the exact words, but in John Cochrane's paper, he has something like the dinner with lion's test where it's if you're eating dinner with lions, you might be the dinner, something like that. The same thing with factor investing, make sure you're not dinner.
Cameron Passmore: Yeah, and know what you're getting into. That was awesome. Okay, anything else to finish up this week?
Ben Felix: No, I think that's good. That's it for the episode.
Cameron Passmore: Awesome. Well, thanks everybody for listening as always.
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'Settling the Size Matter' — https://jpm.pm-research.com/content/early/2020/11/04/jpm.2020.1.187.abstract
'A Wealth Management Perspective on Factor Premia and the Value of Downside Protection' — https://jpm.pm-research.com/content/43/3/33.short
'Volatility Lessons' — https://www.cfainstitute.org/en/research/financial-analysts-journal/2018/faj-v74-n3-6
'Model Comparison with Transaction Costs' — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3805379
'Is There a Replication Crisis in Finance?' — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3774514
'Does Academic Research Destroy Stock Return Predictability?' — https://onlinelibrary.wiley.com/doi/10.1111/jofi.12365
'Which Alpha?' — https://academic.oup.com/rfs/article-abstract/30/4/1316/2758634
'Choosing factors' — https://www.sciencedirect.com/science/article/abs/pii/S0304405X18300515