2D·

Outperforming the MSCI World with factor investing

What do you think about factor investing? Based on personal preferences and research, I have created a simple sample portfolio to illustrate the potential of this strategy. I compared it with the MSCI World Index $IWDA (+1.34%) index.

The results are quite convincing - the factor-based portfolio outperforms the benchmark in terms of both return and risk-adjusted performance:

Annualized Return:

Factor portfolio: 9.02%
MSCI World: 6.42 %

Volatility (standard deviation):

Factor portfolio: 14.76
MSCI World: 14.48

Sharpe Ratio:

Factor portfolio: 0.55
MSCI World: 0.39

Maximum drawdown (during the 2008 financial crisis):

Factor portfolio: -47.7%
MSCI World: -56.5%

Value at risk (VaR, 95% confidence, 1 year):

Factor portfolio: -14.5
MSCI World: -16.5 %

This suggests that a well thought-out factor portfolio can achieve higher returns and at the same time manage downside risk better than a broad benchmark such as the MSCI World.

I look forward to hearing your opinions or how this compares to strategies you are currently pursuing.

28 Comments

Uwe@SchlaubiSchlumpf

Let me throw my portfolio target allocation into the ring. It comes pretty close to your idea.
30% $XDEM (Word Momentum)
10% $XDEB (still unsure whether I want to swap this for 10% more value) (Word min. Vola)
11% $XDEV (World Value)
28% Smallcaps Value ( 6,5% $DGSD, 14,5% $ZPRV, 7% $ZPRX )
4.5% $ALAT (EM Lat America)
6.5% $5MVL (EM Value)
10% Gold $EWG2

Strictly speaking, I still have some REIT (Realty income), Bitcoin and Epis 3xGTAA, but these are not part of my monthly savings rate with rebalancing.
I threw out the World Quality because there were too many ETFs for me and I still have enough factors in there. Opinions seem to differ as to whether minimum volatility is a factor. Empirically, however, it seems to work. Overall, I am very value-heavy, but I don't think you can lump SC Value in with Value on World. I found Latin America quite nice to reduce the China portion somewhat and Lat America is not so big in EM and is currently cheaply valued, so it is also value.

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Chris@PassiveAggressive

@SchlaubiSchlumpf Exciting portfolio.

I also find the favorable P/E ratio of Latin America interesting as a medium-term bet. However, I have decided not to include it in the portfolio, as strictly speaking it amounts to a sale as soon as the catch-up rally has taken place and the region is valued normally again.

For passive factor investing, I prefer products in which I can simply remain invested permanently because they handle the rebalancing internally based on the factors.

Is there a specific reason for your choice of single factor Momentum Value etc. in individual ETFs instead of a multi-factor approach in a product such as $JPGL?

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Uwe@SchlaubiSchlumpf

@PassiveAggressive Yes, that's right. The Lat. America doesn't really fit the B&H factor approach. I should look for a Schiller P/E ratio here at which I can jump off.

The main reason for me was that I wanted to get a little out of my China/Asia focus in EM and I found the idea quite funny. But it's the main inconsistency, that's true.

Actually the factors momentum, value, small caps and political risk.

The main reason is that I have no idea how all the multi-factor ETFs are weighted. So I have the illusion of some control. I was not yet familiar with the multifactor ETF you mentioned. In general, many of the multifactors were also a bit expensive for me with a TER greater than or equal to 50. Apart from that, I am less dependent on ETF closures or shifts to other countries (looking at you Amundi 😏) of a single ETF.

The disadvantage is obvious. I have a confusing portfolio; some ETFs (EM Smallcap Value, for example) are very expensive; rebalancing is only good from a tax perspective as long as I can manage it with additional purchases or within the tax-free allowance.

Maybe I'll change my approach at some point. At the moment, if an ETF fluctuates too much, I see whether I rebalance over several months, i.e. proceed without selling, or whether the deviation becomes too extreme and I sell. I have already been able to sell gold tax-free for rebalancing. Once I rebalanced tax-free this year thanks to the tax-free allowance. Of course, it will become more difficult at some point...

With momentum and value, I have factors that I think complement each other quite well. Initially I had 10% quality in there for a while. I said goodbye to that in order to simplify.
Small caps should also perform somewhat more independently of the two.

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Sauerland_Investor@Sauerland_Investor

How does that work exactly? Buy the ETFs once and then let them run, i.e. invest passively as usual?

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Arthur@NasdaqNinja

@Sauerland_Investor Factor investing means targeting specific characteristics - such as value, momentum or quality - within a benchmark such as the MSCI World. These factors have historically generated so-called factor premiums and thus excess returns. Yes, this strategy can be implemented passively by holding ETFs that track these factors over the long term.

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Sauerland_Investor@Sauerland_Investor

@NasdaqNinja ok thanks. If you can just let the ETFs run and don't have to sell below the 200-day line like the holy Amumbo, for example, that's actually a great thing.

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Pope Donkey XXI@DonkeyInvestor

@Sauerland_Investor see also

Beat the MSCI World in the long term (>= 30 years) without effort.

World vs. World Momentum Index

https://getqu.in/CDEnfS/

World vs. World Quality Index

https://getqu.in/HhbBYl/

World vs. World Value Index (+ conclusion)

https://getqu.in/TD3OT2/

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Arthur@NasdaqNinja

@DonkeyInvestor A valuable addition to your post would be to look at the rolling 5-year regression analysis of the factor premiums in each individual fund. This would show how consistently and reliably each factor has generated excess returns across different market phases. It is particularly interesting to observe how the strength of the factor premiums has changed over time.

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Pope Donkey XXI@DonkeyInvestor

@NasdaqNinja certainly. But it's too time-consuming for me. I'm only here for the fame. And that's what you get 😁

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Arthur@NasdaqNinja

@DonkeyInvestor I would love to show you my regression analysis, especially because of your large range. However, the data comes from my university and cannot be shared publicly. However, I could replicate the analysis with publicly available data and send you the results.

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Pope Donkey XXI@DonkeyInvestor

@NasdaqNinja I think the range is very similar for everyone on getquin. I've been relatively inactive lately. So my fame is waning. But if you have something that's exciting, I'll be happy to (re-)post it

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market_expert_2275@market_expert_2275

17H

@NasdaqNinja that would be really interesting! @DonkeyInvestor

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Stulle 🥪@Stullen-Portfolio

Let me throw an active ETF into the ring or rather into the discussion: $IQSA combines the three (most successful) factors of momentum, quality and value. As I said, it is active - but perhaps it makes sense to be able to take into account the cyclicality of the factors, possibly through active management. However, it has only been on the market for around 6 years.

Any opinions on this?

Greetings
🥪

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Arthur@NasdaqNinja

@Stullen-Portfolio Personally, I am not a fan of IQSA.L as it is an actively managed fund. This means that the managers can adjust the factor allocation of the portfolio depending on the phase of the economic cycle. While this flexibility allows for tactical decisions, it also comes with the risks of active management.

As the chart shows, the fund actively manages its factor exposures. A negative exposure to the profitability factor (RMW) is currently noticeable, indicating a move away from more profitable companies. This type of dynamic allocation is not in line with my investment approach.

I prefer a passive strategy where I have a constant exposure to my chosen factors without relying on market timing. Also, the ESG mandate of the fund does not match my personal investment preferences. The chart can be seen here. https://drive.google.com/file/d/1skK8Gp52PkffFZpBPSo81jFMBB0-uIHo/view?usp=sharing

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Arthur@NasdaqNinja

@DonkeyInvestor Here is an example of a regression analysis of a factor fund ;). I will do the same analysis for the funds you mentioned, but I am busy with my exams at the moment

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Pope Donkey XXI@DonkeyInvestor

@NasdaqNinja Where is the example? Good luck

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Arthur@NasdaqNinja

@DonkeyInvestor In the Google Drive link that I sent in the reply to Stulle

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Susanne@Isus01010

I've looked into it a bit and have a bit of small cap and a bit of value in my portfolio. Did you deliberately leave out the EM? The quality ETFs I looked at were very similar to my World ETF ESG in terms of the large positions. So I left them out.

There is also a sample portfolio according to Kommer on the subject https://www.justetf.com/de/public-portfolio-profile.html?portfolioGroup=EXPERT&publicPortfolioId=15439511

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Arthur@NasdaqNinja

@Isus01010 Yes, I deliberately left out emerging markets. Studies show that factor premiums in developed markets are statistically more significant and reliable over the long term. It is worth noting that individual factors such as small caps and value have underperformed recently - factors can underperform over longer periods, but tend to outperform over the long term. Which factors and regions to choose should ultimately be based on each investor's individual preferences and beliefs.

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Susanne@Isus01010

@NasdaqNinja I have a bit of everything - that doesn't hurt. The gold I bought when the headliners were "gold has had its day" has tripled in value 😅

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Klein-Anleger1@Klein-Anleger1

And how exactly does the strategy work now? As of now, it doesn't help me that much...

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Arthur@NasdaqNinja

@Klein-Anleger1 The strategy works by investing in ETFs that systematically select stocks based on certain characteristics - so-called factors - such as value (undervalued stocks), momentum (stocks with a recent strong price performance) or quality (financially sound companies).

Instead of tracking the entire market as with traditional index funds, shares with these characteristics are weighted more heavily in order to achieve a higher return in the long term. You don't have to select the shares yourself - the ETFs do this for you - and you can hold them passively, just like a normal index fund.

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Pope Donkey XXI@DonkeyInvestor

@Klein-Anleger1 take a look here, Manfred

Beat the MSCI World in the long term (>= 30 years) without any effort.

World vs. World Momentum Index

https://getqu.in/CDEnfS/

World vs. World Quality Index

https://getqu.in/HhbBYl/

World vs. World Value Index (+ conclusion)

https://getqu.in/TD3OT2/

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Klein-Anleger1@Klein-Anleger1

@DonkeyInvestor Thank you dear donkey 🫏
Here to the feeding 🥕🥕🥕🥕

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Pope Donkey XXI@DonkeyInvestor

@Klein-Anleger1 You're welcome, Manni 😘

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Chris@PassiveAggressive

I am a (multi)factor investor myself and therefore a great friend of the topic.

Contrary to some of the ETF recommendations here, however, overweighting individual factors would be too time-consuming for me, especially when it comes to rebalancing. In addition, the combination of several factors in a joint ETF should also perform better than a collection of individual factor ETFs.

For example, if I buy a momentum ETF, it currently focuses heavily on large growth stocks à la $NVDA. If I buy a pure value ETF at the same time, it will invest in the exact opposite. It would be smarter to choose a multi-factor approach that buys value stocks with momentum. I can recommend the book "Your complete guide to factor-based investing" by Berkin and Swedroe. It's a bit of a nerdy read, but anyone who enjoys reading something like this will appreciate it.

My current favorites are $JPGL for the large- to midcaps and $AVWS for the smallcaps. The SPDR ETFs $ZPRV and $ZPRX are also exciting, but I miss the whole Asia-Pacific region here and I don't want to have to do the rebalancing between Europe and the USA manually.

Two more sentences on the active vs. passive debate: ETFs such as $AVWS or $IQSA
are active by definition, but unlike the well-known active ETFs from Ark-Invest, for example, they invest based on rules.

The only difference to an ETF based on the MSCI World Value Index, for example, is that it is not an index provider but the fund company itself that sets the rules according to which investments are made. So there is no active stock picking (which I would not pay for), but an investment based on scientifically sound rules.

In fact, this can be even better than an index-based approach, as indices are not optimized in terms of transaction costs or taxes - this is the reason why many ETF providers only track indices via sampling. Providers of active but rules-based products can optimize in this respect, which can be beneficial to returns. Dimensional and Avantis are both companies that use this concept. Ben Felix has a very good video about this on YouTube: https://www.youtube.com/watch?v=mqIHa6URUPk - Don't be put off by the provocative title. He is a strong advocate of index and rules-based investing...

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Arthur@NasdaqNinja

@PassiveAggressive What a great post - thanks so much for sharing!

Whether one builds a portfolio based on single factors or prefers a multi-factor approach, as you have done, is ultimately a matter of taste. In my view, both strategies make perfect sense.

Your criticism of individual factors such as momentum and value is justified. These objections are particularly relevant if a multi-factor fund does not have statistically significant positive factor loadings over time - i.e. does not show consistent exposure to the targeted factors. This is not always the case, as I have shown in another commentary on IQSA: The loading on the quality factor is actually negative for this fund. (See image: https://drive.google.com/file/d/1skK8Gp52PkffFZpBPSo81jFMBB0-uIHo/view?usp=sharing)

Personally, I am a big fan of JPGL - this fund seems to achieve a very good exposure to the target factors. You can find the results of my regression analysis here: https://drive.google.com/file/d/10VwvL2XoHKF7C1sVdMRlVufZMKjGXNYr/view?usp=sharing. For me, exposure to ZPRV and ZPRX is completely sufficient.

Your comment on $AVWS and $IQSA was also extremely insightful - I wasn't aware of that in such depth. And finally: I'm also a big fan of Ben Felix and have the book Your Complete Guide to Factor-Based Investing by Berkin and Swedroe on my shelf.

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Uwe@SchlaubiSchlumpf

One question, are you sure that $JPGL checks that the values it contains include several factors? If I look at the investor information, it could also be interpreted as simply dividing into thirds.

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