Do This Before Including ‘Factors’ in Your Portfolio
The best and brightest research on investing may sound like a sure thing, but before venturing off into Ph.D.-level academia, investors should master personal finance 101. It could deliver a better payoff.
Pioneering research from Eugene Fama and Kenneth French started in 1993 has shown that there are several “factors” that contribute to investment performance. Their research identified three variables that contribute to a stock’s performance:
- Value: Stocks purchased at low price-to-book ratios have higher returns.
- Size: Smaller companies outperform their larger counterparts.
- Beta: Riskier investments produce higher returns.
Tilt your investment portfolio toward these factors and, if history is any guide, you should outperform the general market. Dimensional Fund Advisors (DFA), is most famous for using investing factors in their funds. Since 2000, 82% of DFA’s funds have beat their benchmarks, according to DFA.
Just how significant an outperformance do DFA funds achieve? I looked at every DFA fund with a 10-year history of returns and compared those returns to their benchmarks, then found the average outperformance: 0.29% per year. Factor in an assumed 0.1% expense ratio to invest in an index fund that tracks the same benchmark and you get an annual outperformance of 0.39%.
So why not jump on the factor bandwagon?
First of all, it’s complex. If you are not ready to manage such a portfolio yourself you need to go through an adviser who has completed DFA’s vetting process. This adds another layer of expenses, likely voiding any benefit of the implementation of factors into your portfolio (on investment performance alone, not factoring in other benefits an investment adviser’s advice may provide).
Second, and most important, there are many things that you are likely not doing that have a much larger effect on your long-term portfolio returns. Employing these tactics, the average investor can likely boost their long-term returns by more than 0.39% today, no Ph.D. in economics required:
Invest with Taxes in Mind
With income tax rates as high as 39.6%, any way you can find to reduce your tax burden is important. A few smart tax moves can save you more than factor investing can gain.
First, allocate your investments wisely. Are investments that distribute large capital gains, high-dividend- yielding investments or fixed-income investments, invested outside of tax-advantaged accounts? Properly allocating investments into correct account types can easily save investors hundreds or thousands per year.
Next, take advantage of low long-term capital gains tax rates. While short-term capital gains are taxed at your normal income tax rate, tax rates on long-term capital gains are much lower. Married households with under $75,900 in income or single filers with incomes under $37,950 pay no taxes for long-term gains. Even for those with much higher incomes, long-term tax rates are capped at 20%, while your income tax rate may be as high as 39.6%. Whether you are selling investments to rebalance your portfolio or raise cash, ensure you have held your holdings more than a year before selling.
Last, sell your losers. Tax-loss harvesting allows investors to write of as much as $3,000 in investment losses each year. For any diversified investor, finding something that is down should not be hard. Own energy or commodity investments this year? You are likely able to take advantage of loses now to help offset any other gains or income.
Trade Less Frequently
No matter what investments you use, letting your emotions take control of your investing will hurt your results. Less trading can help investors in two ways; you pay less in commissions, and you are less likely to mistime market moves.
First, commissions. Assume you pay $4.95 for each trade and execute one buy and one sell per month. This will cost you $118.80 per year in commissions. If you have under $30,400 (which according to the Economic Policy Institute if you are age 37 or under, you likely do) in investments and trade once per month, your commissions alone eat away any advantage factors have provided.
Second, and most important, is the impact of actively trading. On average, active traders underperform the general markets. Barber and Odean found the average active investor underperformed by 1.5% annually between 1991 and 1996. Last year, DALBAR found the performance gap last year was even worse at 4.7%!
History has shown that investing in factors has boosted returns, but only if you maintained a disciplined, long-term investment approach. Factor investing can underperform over any short-term period. If you can’t keep your emotions in check, you will not find any net benefit including factors in your investments.
Take advantage of your employer match
Not only do your contributions into a workplace retirement account reduce your current tax burden, many companies will match your contributions.
According to a 2015 study by Financial Engines, 25% of employees leave a collective $24 billion on the table by not contributing up to their company’s match in workplace retirement accounts. The average worker could save an additional $1,336 per year by taking full advantage of their employer’s match.
A company match is free money. Before worrying about your specific investments, ensure you are getting the most money possible in your retirement accounts.
Should You Worry About Adding Factors to Your Portfolio?
The average investor has a lot to worry about before considering whether or not to add factors into their investments. Factor investors certainly have a place in the investment world, but make sure you have mastered the basics first.