At Savant, we believe in an evidence-based approach to investing, leveraging specific characteristics or “factors” that can potentially drive higher returns and help manage risk more effectively. This approach, rooted in academic research and empirical data, aims to create diversified portfolios that help optimize returns by systematically targeting these factors.

A Brief History of Factor Investing

Factor investing has its roots in the foundational work of financial economists who sought to understand the underlying drivers of stock returns.

  • Capital Asset Pricing Model (CAPM): Developed in the 1960s by William Sharpe and others, CAPM introduced the concept of beta, measuring a stock’s sensitivity to market movements, and laid the groundwork for modern portfolio theory.
  • Three-Factor Model: In the early 1990s, Eugene Fama and Kenneth French expanded on CAPM by identifying two additional factors – size and value. Their research demonstrated that small-cap stocks and value stocks tend to outperform the market over the long term.
  • Further Developments: Subsequent research identified additional factors such as momentum, quality, and low volatility. These discoveries have been extensively documented in academic literature and have shaped the field of quantitative finance.1

What is Factor Investing?

At its core, factor investing involves selecting securities based on attributes associated with higher expected returns. The most recognized factors include value, size, quality, and momentum. At Savant, we primarily focus on value, size, and quality while indirectly incorporating momentum through our managers’ strategic decisions.

The Key Factors

Value

The value factor focuses on investing in stocks priced lower relative to their fundamentals, such as earnings, dividends, or book value. Historically, value stocks have outperformed growth stocks, driven by the tendency of the market to eventually correct the undervaluation.

Historical Performance: Over the long term, value stocks have delivered higher returns. However, there have been periods, particularly in recent years, where value has underperformed growth. This cyclical nature should be expected and understood as part of the investment journey.

Historical Value Annual Return Premium 1973-2023

U.S. Large Core and U.S. Large Value

Source: Morningstar Direct; U.S. Large Core: S&P 500 TR Index (1/1970-6/2000), CRSP US Total Market TR Index after 6/2000, U.S. Large Value: Fama-French Large Value (1/1973-1/1987), Russell 1000 Value TR Index after 1/1987. Past performance is not indicative of future results. Indices and benchmarks are unmanaged and cannot be invested in directly.

Size

The size factor targets smaller companies (small-cap stocks) that tend to outperform larger companies (large-cap stocks) over time. This premium is attributed to the fact that smaller firms are more nimble, have higher growth potential, and are also exposed to greater risk.

Historical Performance: Small-cap stocks have historically outperformed large-cap stocks, especially in periods of economic recovery. Yet, they can be more volatile and susceptible to economic downturns. The recent underperformance of small-cap stocks is a reminder of their riskier nature but also highlights the potential for future gains as market conditions change.

Historical Small Cap Annual Return Premium 1973-2023

Source: Morningstar Direct; U.S. Large Core: S&P 500 TR Index (1/1970-6/2000), CRSP US Total Market TR Index after 6/2000, U.S. Small Cap: IA SBBI US Small Stock TR (1/1973-12/1978), Russell 2000 TR Index after 12/1978. Past performance is not indicative of future results. Indices and benchmarks are unmanaged and cannot be invested in directly.

Quality

The quality factor emphasizes investing in companies with strong fundamentals, such as high profitability, low debt, and stable earnings. These companies are often more resilient during economic downturns and can help provide consistent performance over the long term.

Historical Performance: High-quality companies tend to exhibit lower volatility and more stable returns compared to lower-quality companies. This factor complements the value and size factors by adding a layer of financial robustness to the portfolio.

Historical Quality Annual Return Premium 1973-2023

Source: Morningstar Direct; U.S. Large Core: S&P 500 TR Index (1/1970-6/2000), CRSP US Total Market TR Index after 6/2000, U.S. Large Quality: Fama-French US High Profitability Index (1/1/1973 – 11/1988), MSCI USA Sector Neutral Quality GR after 11/1988. Past performance is not indicative of future results. Indices and benchmarks are unmanaged and cannot be invested in directly.


Integrating Factors into Portfolios

  • Diversification: Incorporating multiple factors into a portfolio can help enhance diversification and potentially reduce risk. For example, combining value, size, and quality can balance periods when one factor underperforms.
  • Systematic Approach: Factor investing is most effective when applied systematically. This means consistently adhering to the criteria for selecting stocks based on the targeted factors, without succumbing to market timing or emotional biases.
  • Long-Term Perspective: Factors can go through cycles of outperformance and underperformance. Maintaining a long-term perspective helps investors stay committed to their strategy through various market conditions.

Risks

Factor investing, while offering the potential for higher expected returns and broader diversification, comes with its own set of risks. Factors like value and size tend to perform well at different parts of the economic cycle and may not always be highly correlated with equity market moves. Additionally, factors may experience long periods where premiums are negative, increased volatility, and the risk of being arbitraged away over time. With this in mind, it is important to remember:

  • Value Factor: Despite recent challenges, value investing remains a cornerstone of a robust investment strategy due to its long-term track record.
  • Size Factor: The volatility and higher risk associated with small-cap stocks are balanced by their potential for higher returns, making them a valuable component of a diversified portfolio.

Conclusion

Factor investing can help offer a disciplined, research-driven approach to portfolio construction that’s designed to help enhance returns and manage risk. By understanding and leveraging factors such as value, size, and quality, investors can build diversified portfolios positioned to align with their long-term financial goals. While factors may experience periods of underperformance, we believe their inclusion as part of a comprehensive investment strategy remains critical to capturing the benefits of broad market exposure and disciplined investing.

  1. Eugene F. Fama, Kenneth R. French, A five-factor asset pricing Model, Journal of Financial Economics, Volume 116, Issue 1, 2015, Pages 1-22.
  2. Asness, Cliff S. and Moskowitz, Tobias J. and Moskowitz, Tobias J. and Pedersen, Lasse Heje, Value and Momentum Everywhere (June 1, 2012). Chicago Booth Research Paper No. 12-53, Fama-Miller Working Paper

This is intended for informational purposes only. Past performance is no guarantee of future results. Historical performance results for investment indices, benchmarks, and/or categories have been provided for general informational/comparison purposes only, and generally do not reflect the deduction of transaction and/or custodial charges, the deduction of an investment management fee, nor the impact of taxes, the incurrence of which would have the effect of decreasing historical performance results.

Author Chip Kalousek Senior Investment Strategist / Client Advisor

A seasoned investment professional dedicated to client relationships and financial education, Chip leads Savant’s investment content creation and strategic initiatives while providing tailored guidance to help empower clients to pursue their unique goals.

About Savant Wealth Management

Savant Wealth Management is a leading independent, nationally recognized, fee-only firm serving clients for over 30 years. As a trusted advisor, Savant Wealth Management offers investment management, financial planning, retirement plan and family office services to financially established individuals and institutions. Savant also offers corporate accounting, tax preparation, payroll and consulting through its affiliate, Savant Tax & Consulting.

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Savant Wealth Management (“Savant”) is an SEC registered investment adviser headquartered in Rockford, Illinois. Past performance may not be indicative of future results. Different types of investments involve varying degrees of risk. Therefore, it should not be assumed that future performance of any specific investment or investment strategy, including the investments and/or investment strategies recommended and/or undertaken by Savant, or any non-investment related services, will be profitable, equal any historical performance levels, be suitable for your portfolio or individual situation, or prove successful. Please see our Important Disclosures.