6 Formulas That Will Beat The Market
How effectively are investors using “factors”—those monetary characteristics influencing a stock’s performance? It’s excellent news if factors are intended to be effective stock-picking tools. It implies that you may have a comfortable retirement without putting in a lot of effort to manage your investments. If they fail, it will serve as an essential lesson about trying to outperform the market, which I will discuss after this piece. It will take another 40 years or more before we can definitively judge factors, but my initial impression is that factor-based investment will fail.
Factors were an idea reserved for academia before becoming marketed on Wall Street. Professors would sift through a sea of stock return data, searching for trends. They located a few. The job was intriguing. It led to several Nobel Prizes. Beta was the initial factor identified by Harry Markowitz in the 1950s. When you regressed the returns of stocks in high-risk firms against the returns of a market composite, the stocks of those companies would show a high beta coefficient (either due to their industry or their leveraged balance sheets). According to the notion, high-beta stocks will eventually outperform low-beta equities.
Does that idea still hold? Kind of. A high-beta portfolio will likely yield a high return if you can handle high volatility. But investing in high-beta equities doesn’t offer advantages over borrowing money to buy just mediocre firms. Thus, investor wealth has not increased due to the beta insight.
Value Line, the publisher of a widely read investing survey, launched a new weekly rating system that informed its members of the hottest stocks ten years after Markowitz completed his landmark work. The strategy was made up of a number of parts, but at its core was momentum investing. It made use of the fact that stocks of businesses that were providing upbeat earnings shocks and that had lately excelled tended to continue to do so for a time. On paper, the ranking system produced terrific results. A hypothetical investor who followed Value Line’s advice for the first 22 years would have realized investment income averaging 23% a year. The total for the 1,700-stock range in the Value Line Investing Survey was almost tripled.
Can a mechanical rule outperform the market? That would go against the efficient-market hypothesis, which holds that stock results are determined mainly by chance. EMH supporter and economist Fischer Black (of the Black-Scholes option equation) was astounded. He called the Value Line system a puzzling aberration. In actuality? A different narrative. Value Line launched a mutual fund to maintain a portfolio of highly rated stocks. The fund failed miserably. It was unable to match the average market return, much less the fictitious market-beating return.
What happened? The fund manager competed with investment survey subscribers by paying prices that were in effect after survey findings were made public when purchasing freshly upgraded equities. The paper performance was based on pricing recorded two days before, which was a different factor. It turned out that practically all of the excess returns from the survey occurred in the few days before its release and were not accessible to investors. The size factor comes after beta and momentum. According to a well-known 1981 article initially intended to be a Ph.D. dissertation, small-company stocks outperform big-company equities over extended periods. Following that announcement, money managers scrambled to build small-stock portfolios.
Unfortunately, the small-stock anomaly disappeared as soon as it was found. Based on a record of stock returns collected by market theorist Kenneth French for 1927 through 1981, stocks in the smallest market-value quintile outperformed with an annual return of 18.1% as opposed to 8.6% for large-cap stocks. The two deciles have been tied at 12.6% ever since. The scholars continued their investigation and found other oddities. They capitalized on qualities like quality (stocks of businesses with solid balance sheets and high margins outperform), value (stores selling at low multiples of earnings or book value exceed), and low volatility (sleepy stocks outperform on a risk-adjusted basis). And in each instance, Wall Street marketers were poised to profit with new product lines.
The scholarly research had validity since they correctly identified investing strategies that were wise in retrospect. If you had known to use them at the start of the investigated period, you might have been wealthy. That does not imply that you will succeed after the abnormality is discovered. Factor investing reached a fever pitch a few years ago with the rise of what is now referred to as “smart-beta” fund portfolios. When even Vanguard, the pinnacle of passive investment, joined the gold rush, you realized we had reached a frenzied climax.
Vanguard introduced six-factor ETFs in February 2018. The five fundamental flavors are the trend, quality, value, low volatility, and low liquidity. (The final one related to the size factor is that investors must be compensated for tolerating obscure stocks.) The first four tastes are combined into a single portfolio by a fund known as tutti frutti. How did they fare? Not good. Since then, the momentum fund, which includes equities like Tesla and Nvidia, has barely managed to keep up with the market. The remaining five are now behind. The yearly return of the market-leading multifactor fund lags by 2.8 percentage points.
Purchasing these losers at this time wouldn’t harm. The Vanguard funds will gain momentum after a sluggish start, and over their first 40 years, they will precisely tie the market, just as small stocks have done over the previous 40 years. However, if you wish to secure the market, acquiring an index fund might save you a lot of hassle. This leads to a short lesson about market-beating strategies in general, not just smart beta. I took it from a foresighted Forbes piece published in 1982 that questioned the idea that small-cap companies will consistently outperform large-cap ones.
