The Case for Factor Indexing from a Nobel Prize Laureate
Nobel Prize laureate in economic sciences Eugene Fama and famed Dartmouth College professor Ken French developed the Fama-French 3 Factor Model in 1992. The model showed promising research on quantitative ways to pursue higher expected returns compared to conventional indexing methodologies. After that, additional research led to a fourth factor being added to their model.
In short, most indexes are weighted by market capitalization. For instance, Apple (AAPL), the largest stock in the S&P 500, represents 3.79% of the index and TripAdvisor (TRIP), the 498th, is a mere 0.02 percent of the index. Nothing wrong with the weighting by market capitalization, but Dr, Fama and Dr. French conducted extensive research into weighting a pool of stocks in a different way in order to increase the expected rate of return.
What they discovered was that four factors exhibited the characteristics they wanted in the way they wanted through a variety of market conditions and cycles:
- Market capitalization outperforms individual stock picking or timing.
- Small stocks outperform large stocks.
- Value stocks outperform growth stocks.
- More profitable companies outperform less profitable companies.
Note that these factors do not outperform every day, week, month, year or even decade, but they have statistically proven to bode well over long periods of time.
Enter Factor Oriented Funds & ETFs
So, enter into the investment fray index-like pools of stocks that are not weighted by capitalization, but rather, use one or more of the four factors above to weight and even filter a pool of stocks based upon these criteria. This is what is called Factor Indexing, and yes, the evidence is compelling enough for us to utilize within our portfolio management approach here at Janiczek Wealth Management.
While we use some funds that religiously follow the Fama-French 4 Factor criteria, we also selectively utilize other “smart-beta” approaches that fall into this same general category of investment management approach. Just another way we sift through the evidence and provide our clients with not one single approach, but rather, a strategic blend of solid approaches meeting our Evidence Based Investing (EBI) standards.
To read an article summarizing the Fama-French 3 Factor Model, click here.
To read an academic article by Fama and French, click here.