Investment outperformance, part 1: what you invest in

This article assumes that you're already familiar with the basics of investing: how to use your risk tolerance and risk capacity to determine an optimized asset allocation that fits them. That's going to determine the lion's share of your volatility and returns, but what if you're looking for even more efficiency? What if you've got your asset allocation set up and want to turn the dial to 11? The magic of compound interest means that small improvements compounded over time add up to huge gains, so let's take a look at some of the options for optimization.

First, a ground rule

I'm not talking here about speculation. If you have a crystal ball that tells you that TSLA is going to turn into TSLAQ, or that Apple stock is going to split yet again, well then by all means: put your life savings into the appropriate purchase, or short sell, or option strategy of choice, and prepare to get rich. I just hope your crystal ball isn't fueled by Internet comments or a paid investment newsletter subscription...

But no, we're not talking about that, so I'm not going to talk about limit orders or calls or puts or iron condors or golden pterodactyls or whatever. We're the casino, remember? Not a player in it.

So what's left?

But if we rule out speculation, how do we outperform? If markets price efficiently, what more is there for us to do? As it turns out, there are several ways to add "alpha": increased returns that aren't just a result of the added reward you get from taking on more risk. Some of them have to do with what you invest in -- "tilts" to your asset allocation -- and some of them have to do with how you invest. This article is going to talk about the "what", and next week, we'll talk about the "how".

"Tilts": factor-based investing

Regardless of the efficiency of the market, it's clear that some investments that have statistically higher expected returns than others. The easiest example to think of is stocks: because of their higher volatility, they offer a "premium" over bonds. You accept more risk, you get more returns. ("But I thought we were looking for increasing returns without taking on more risk?" Good point, and we'll get there in a few paragraphs!) There are other factors out there, as well, though some of them are more proven than others.

But first, let's lay out what constitutes a "factor of increased returns". This can't be some "here today, gone tomorrow" anomaly that some smart analyst discovered but will vanish once everyone else knows it's there. No, this needs to be something that's "persistent, pervasive, robust, investable, and explainable", to use investment researcher Larry Swedroe's terms. There are five such factors on the stock side, and two on the bond side. To go over them briefly:

Beta: Beta, simply put, is how much the stock moves with the market. High beta = high volatility, high returns. Low beta, low volatility (relatively speaking), lower returns.

Size: Smaller stocks tend to outperform larger stocks. Why? Because it's easier for them to go bankrupt!

Value: Stocks that are underpriced relative to the net value of their assets tend to outperform stocks that are overpriced ("growth" stocks). Again, there's a higher risk here, with a corresponding reward.

Profitability: Stocks that are underpriced relative to their profitability tend to outperform as well, for nearly identical reasons as value stocks.

Momentum: Finally, stocks that outperform tend to keep outperforming, at least over a few months. There are two popular arguments for why this is the case, one based on behavior (investors tend to underreact and/or have delayed overreaction), and one based on risk (momentum investing increases exposure to "crash risk", the risk that a given investment will be particularly bad during a market crash, above and beyond their "beta" in normal times). Whichever one is true, both indicate that the momentum premium will almost certainly persist as it has in the past.

Term: On the bond side, bonds that have longer terms tend to have higher returns than ones that have shorter terms. Longer terms means more susceptibility to interest rate changes, which means more risk, which means a premium.

Carry: Higher-yielding assets -- ones with higher interest rates relative to their price -- tend to outperform lower-yielding assets. The risk here is similar to value and profitability, and is best illustrated when looking at junk bonds: the yields are higher because the company is more at risk of default. ("Wait -- shouldn't this apply to dividend stocks, as well? Maybe even commodities?" you say. "Good catch," I say. "Gold star for you. While most people talk about the carry premium in the context of bonds, it works everywhere.")

But I don't want more risk!

You spent all this time figuring out your risk tolerance and capacity, and carefully designed an asset allocation that fits them -- the last thing you want to do is take on more risk, right? Why, then, would I even bother talking about factors of increased return that give you more risk?

Well, as it turns out, you can combine them in ways that don't. Remember Dimensional Fund Advisors, that mutual fund company I like to talk about? Well, check out the 20-year analysis that Mr. Swedroe did on DFA and Vanguard. In it, he notes that not only does DFA outperform Vanguard just about everywhere, but he also notes that the Sharpe ratios (risk-adjusted returns) are higher, as well!

Wait, so I'm taking on more risk, but it's increasing returns without increasing volatility? What sorcery is this?

(If that phrase sounds familiar, it's because I've used it before -- and if you remember where it came from, you've already figured out what's going on. Another gold star for you!)

As it turns out, the various factor premiums are pretty uncorrelated. And what happens when you effectively combine uncorrelated factors? Sorcery, in the form of a more efficient portfolio!

Implementing "factor tilts"

How does one go about wielding this black magic? There are two routes one can take, which you can mix and match as you see fit.

Modify your asset allocation. In addition to allocations to broad asset classes (e.g. US stocks), you can "tilt" your portfolio towards factors of increased returns by adding allocations to factor-based classes (e.g. US value stocks). Just make sure you rebalance systematically! And while you can effectively, easily, and cheaply get exposure to the small and value premiums* this way, the profitability and momentum premiums aren't as readily available. The momentum premium in particular is tricky -- because it is by nature ephemeral, any fund that tries to track it is going to be doing a lot of trading, which will bury your premium in costs!

Invest in (low-cost) multifactor funds. DFA's "US Core Equity Portfolio" fund invests in US stocks, with a tilt towards the factors I mentioned above -- and it does the rebalancing for you. DFA even works to capture the momentum premium, not by using it to dictate its trades, but to guide the timing -- if a stock is due to be sold but is exhibiting momentum, they might delay selling it in order to capture that premium. Of course, the premium needs to outweigh the expense ratio, so these funds need to be low-cost! (For comparison, as of 2018, the fund mentioned above (DFEOX) is 0.19%, within striking distance of Vanguard's Large Cap Index fund (VLACX), at 0.17%.)

A note of caution. I'm not recommending you try and combine the above factors willy-nilly. Every factor has the potential to introduce so much volatility as to not increase your risk-adjusted returns, some (e.g. term and carry) more so than others. This is another reason to invest in multifactor funds -- they've run the numbers to figure out which factors to use in which proportions!

Next up: how

Above are some ways you can change what you invest in to optimize your risk-adjusted returns. Next week, we'll talk about optimizing how you invest to take things even further!

(And if you're interested in Seaborn's investment management offering, you can check that out as well.)

* Sorry-not-sorry, grammar nazis.

Britton is an engineer-turned-financial-planner in Austin, Texas. As such, he shies away from suits and commissions, and instead tends towards blue jeans, data-driven analysis, and a fee-only approach to financial planning.