May 1, 2025 • 42 mins
Questions? Thoughts? Send a Text to The Optometry Money Podcast!
How can optometrists improve their portfolios beyond basic index funds, without risky trading? Evon Mendrin provides an OD's guide to Factor-Based Investing.
Evon discusses:
- What factors are and their role in investment returns.
- Five criteria to identify reliable investment factors.
- Key factors: Market, Small, Value, Profitability, Investment, and Momentum.
- Why factors exist, explained through risk and behavioral finance.
- Common misconceptions around factor investing.
- Practical tips for implementing factors in your portfolio, including tilting and core-and-satellite approaches.
- Who should and shouldn’t consider factor investing based on goals and risk tolerance.
This episode highlights a disciplined, long-term investment strategy. While it's certainly not guaranteed, it can be an evidence, research-backed approach to improving your portfolio without falling into the trap of active investment trading.
Resources Mentioned:
- Ep 94: Why Active Investment Management Fails with Andrew Berkin, PhD
- "Your Complete Guide to Factor-Based Investing" by Andrew Berkin and Larry Swedroe
- Movie: DFA's Tune Out The Noise
Questions?
Email Evon at podcast@optometrywealth.com.
Stay Connected:
- Click here to Subscribe to the Eyes On The Money Newsletter for weekly financial insights tailored specifically to optometrists.
- Have Questions? CLICK HERE to schedule a short introductory call
If you enjoyed this episode, please leave a review and share it!
Thanks for listening!
The Optometry Money Podcast is dedicated to helping optometrists make better decisions around their money, careers, and practices. The show is hosted by Evon Mendrin, CFP®, CSLP®, owner of Optometry Wealth Advisors, a financial planning firm just for optometrists nationwide.
Mark as Played
Transcript
Episode Transcript
Available transcripts are automatically generated. Complete accuracy is not guaranteed.
Evon (00:04):
Hey everybody.
Welcome back to the OptometryMoney Podcast, where we're
helping ODs all over the countrymake better and better decisions
around their money, theircareers, and their practices.
I am your host, Evon Mendrin,Certified financial planning
practitioner and owner ofOptometry Wealth Advisors, an
independent financial planningfirm just for optometrist
(00:24):
nationwide.
And thank you so much forlistening.
Really appreciate your time andattention.
And on today's episode, I'mgoing to continue the sort of
investment series that I'm on,and we'll dive into an
optometrist guide toFactor-based investing.
In the last episode, episode134.
I dove into why Optometry shouldembrace passive investing and
(00:47):
index investing index funds, andI dove into the history and the
research and academic rootsbehind it and why we would
expect index investing to worknow and into the future, and
just why it is so unlikely thatactive investment managers,
either you or I, or professionalmanagers managing mutual funds
(01:09):
to outperform their broad marketindexes.
And if you haven't listened tothat one, highly recommend you
go back and listen to that onefirst before jumping into this
one.
Why does this matter?
Well, as optometrists oftenpractice owners managing both
practice and personal finances,you're taking the cash flow that
(01:29):
you get from your work and yourpractice.
And to first reinvest back intoyour practice and then into
investing in other assets.
It could be in your retirementaccounts at work, it could be
into other accounts, it could beinto real estate.
Whatever it is, you're takingthat cash flow and continuing
this habit over and over againof investing it into assets, and
(01:49):
as you do that, you need aninvestment approach that number
one, you understand.
That is expected to work overthe long term, meaning there's
evidence to suggest that itwould work over the long term
and that you can stick with.
And the question that comes outof that discussion around index
investing and broad marketinvesting like that is that,
(02:10):
well, can we improve portfoliosabove and beyond broad market
index funds?
Can we improve our investmentsbeyond just picking the global
stock market index fund that'savailable to us?
Without falling into the trap oftrying to be this really active
investor betting on individualstocks or trying to time the ups
and downs and the evidencepoints to yes, in fact, the same
(02:36):
academic work in fact, a lot ofthe same people that led to
index funds, and that explainswhy Index funds work continues
on.
And it builds on top of itself,which leads us down to the road
of factor based investing.
So what is a factor?
A factor is just a commoncharacteristic across a bunch of
(03:00):
investments.
As academic researchers havework to understand what really
drives markets.
And if we're, we're buying astock, we're buying the future
cash flows of these businesses,and they're trying to understand
or create models to explain howmuch we should be willing to pay
for those cash flows.
(03:21):
Given the risk and expectedreturn of that company, not much
different than if you're buyingan Optometry practice.
And then finally, what explainsthe differences in returns
between different broadlydiversified portfolios, meaning
your portfolio and your peersportfolio, meaning your, just
all of your investments combinedand my, my bundle of
(03:41):
investments, they're all gonnabehave differently.
So what explains the differencesin their behavior and their
returns.
And academic work has broughtout these certain factors or
characteristics are commonacross a bunch of investments
that help to explain variationsin returns.
And this isn't only ininvesting.
(04:01):
So what I, something I'velearned from a peer of mine, a
fellow advisor, is that theyhave factor models or groups of
characteristics, groups offactors for personalities.
There's even a five factor modelthat talks about these five
characteristics that primarilyexplain the differences in
personalities between differentpeople.
(04:22):
They're not the onlycharacteristics, but the
characteristics that have thestrongest ability to explain
differences in personalitiesbetween you or I, or, or a group
of us.
And so we find a similar thinghere in investing where research
has found that certain factorsor characteristics have been
shown to explain the risk andreturn of investments, and
(04:45):
importantly have been shown tohave a higher return over long
periods of time versus theircounterpart, meaning those
factors, those characteristicshave given a premium, an extra
return.
For investing in that group ofcharacteristics rather than
their counterparts.
So what is factor investing?
(05:05):
Well, factor investing istargeting or tilting toward
specific evidence-based stockcharacteristics we're we're
gonna be basically just talkingabout the stock market today
stock characteristics or factorsthat are tied to higher
long-term expected returns.
And what makes a reliablefactor?
(05:26):
there are, if you look at enoughpapers, there are hundreds of
factors proposed out there, alltrying to explain some factor
characteristic that provi leadsto a higher expected return.
sometimes you'll see thisreferred to as the factor zoo,
like everywhere you look,there's a new factor popping up
here or there to, to look at.
a lot of those though are shortterm anomalies that are based on
(05:49):
just pure randomness.
They're, they're not significantor are, or are so small that if
you actually try to invest inthem, just the cost of trading
in managing it would eat awayany of the extra returns.
So they're not really reliablecharacteristics.
there are, there is a small,really small group of commonly
(06:10):
held factors.
That have been shown to berobust and reliable, and there
are some criteria to figure outwhat is a, what makes a factor
reliable.
So in addition to actuallyshowing up in the data and
providing an excess return, wesee five common criteria for
(06:30):
robust, reliable factors.
And Andrew Berkin, who I've hadon the podcast and his
co-author, Larry Swedrow, who doa great job of describing this
in their book, Your CompleteGuide to Factor-Based Investing.
There are five criteria, andthose are, number one, it has to
be persistent, meaning thischaracteristic has to work
across time and differenteconomic regimes.
(06:51):
We can't be cherry picking aparticular five or 10 year
period across a hundred to 200years of of history.
It has to be persistent acrossperiods of time.
Number two, it has to bepervasive, meaning it has to
work across global markets andsectors, even different
categories of investments.
So it has to work acrossgeography.
(07:12):
It can't just work in oneparticular market and not work
anywhere else.
Number three, it has to berobust, meaning it has to hold
up to different definitions andmeasurement of that
characteristic.
We shouldn't have to torture andtease out a very, a very
specific way to describe it inorder for it to work.
Number four, it has to beinvestible.
(07:33):
Meaning that even if it shows upon paper, it ha you have to be
able to actually implement it inreal life.
Cost effectively, and it stillhas to work after costs.
And then lastly, it has to beintuitive.
It has to make sense.
There has to be some logicaleconomic explanation for this.
(07:54):
It can't simply be, Hey, youknow, all stocks that start with
T tend to do better than stocksthat start with S That might
show up in the data, but there'sno economic rationale for why we
should expect that to continue.
And so persistent, pervasive,robust, investible and
intuitive.
You might look at, I don't know,like that diagnostic tool in the
(08:15):
same way, it has to workconsistently.
It has to work across patientpopulations.
You have, it has to work usingdifferent measurement
approaches.
It has to be practical toactually use in your clinic.
And have a clear scientificrationale.
Maybe you have a similarframework for looking at things
like that.
And so if it meets thesecriteria, it's likely not to be
(08:36):
just data mining or just purerandomness, but reliably and
robust something we can expectto continue into the future.
So what are these factors thatwe're talking about?
What are the characteristics?
Well, there is a core set ofthree to five or six
characteristics that are notonly show up clearly in the data
historically, but are widelyaccepted as reliable, robust
(08:59):
characteristics.
And the first one is the marketfactor.
And this is simply your exposureto the stock market as a whole.
The, the entirety of the stockmarket is itself a
characteristic that explains thereturns of a portfolio.
And the premium that it givesyou is often defined as the
return of the stock market minusthe return of short-term
(09:22):
treasury bills, US treasurybills, which are sort of the
risk-free return, right?
There's, there's essentially norisk for those short-term
treasuries.
And so the differences there isthe premium, the extra returns
that you either got historicallyor would accept for taking on
the risk of investing in stocks.
It's often called the equityrisk premium.
(09:44):
This is what you're demanding asan investor for taking on risk.
And this goes back to, 1960s,Bill Sharp's Capital Asset
Pricing Model, which you mayhave heard of if you've taken
any Intro to finance classes.
Or MBA courses, even though themodel itself doesn't work in
real life, it, it's still oftentaught in MBA courses.
And this is also where thatjargon word, if you ever heard
(10:06):
the jargon word beta, this iswhere beta comes from.
It's a measure of something'svolatility relative to the stock
market as a whole.
or if someone says, Hey, you're,you're just getting beta, that
just means you're gettingexposure to the market as a
whole.
And this is really importantresearch, sort of putting,
putting on paper, thisrelationship between risk and
(10:29):
return.
Before this, you know, you canimagine any stockbroker at the
time, anytime there was positiveperformance in client accounts,
they're taking credit for it.
It's, this is, hey, this istheir, their unique skill,
right?
This is their skill that'sproviding that return.
And then research like thiscomes along and says, well, no,
not necessarily.
In fact, all you're seeing thereis investors getting compensated
(10:53):
for investing in stocks as awhole.
This may have nothing to do atall with the skill of the
manager, but this is simply thereturn that clients are getting,
that investors are getting forinvesting broadly in the market
as a whole.
And if stocks or some manager isexpected to have higher returns
in the market, then they're onlydoing that by taking on more
(11:14):
risk.
Not necessarily because of theirskill.
And so the amount of stocks youown, really your exposure to the
stock market is able to explain,statistically about two thirds
or about 66% of the differencesin returns between two mixes of
investments, my mix ofinvestments versus your mix of
investments.
This has a lot of explanatorypower.
(11:36):
Which sort of highlights howimportant of a decision it is
based on your time horizon basedon your investment goals and
just your ability to acceptinvestment risk, how important
of a decision it is, how muchstocks you're gonna have
relative to other things likebonds, and how that changes over
your lifetime as you get closerand closer to needing to use the
(11:57):
funds because this will explainthe majority of your returns and
risk over your, over yourlifetime.
and this is where most people'sknowledge tends to end.
I mean, most of you probablyintuity have an understanding
that yeah, the stock market isriskier than government bonds.
We're, we're expecting becauseof that, to be compensated with
higher returns.
they're not guaranteed.
(12:19):
They're definitely notguaranteed.
In fact, we've seen long years,you know, if we look back at
rolling periods historically.
looking back, for example, inthe US from 1926 through 2024,
over one year periods, thispremium showed up, meaning US
stocks had a higher return thanUS treasuries only 70% of the
(12:40):
time.
Now that's the majority ofyears, but there are still
plenty of years where stocks inthe US did not outperform US
treasuries.
And if you look over five yearperiods of time, that extended
to, 79%, 10 year periods oftime, it's 86%, 15 year periods,
96%.
And then the longer you extendthat time horizon, the more
(13:02):
reliably stocks haveoutperformed government bonds.
But there are long periods oftime where you see that that
premium, that excess returndoesn't show up and it can be
uncomfortably long periods oftime.
So, for example, in the US welook back the last 15 years at
how well US companies didrelative to the rest of the
(13:23):
world and especially the largestUS companies, the largest tech
growth US companies.
and we kind of expect that tocontinue on for the rest of our
lifetimes, but that's notnecessarily the case.
What we do there is we forgetabout the decade before because
the early two thousands, therewas an entire 10 year period
where US stocks did notoutperform government bonds, in
(13:46):
fact provided a slightlynegative return for a full 10
year period for a full decade.
That's a long time, and you haveto be willing to accept that
risk to go through that in orderto get that potential, that
expected higher return.
It's not guaranteed.
There are periods of time whereyou're not gonna see that.
(14:07):
Berkin and Swedrow in that bookI'd mentioned earlier, put it
perfectly well, they say"theimportant takeaways that if you
want to earn the expected butnot guaranteed premium from a
factor, you must be willing toaccept the risks that there will
almost certainly be long periodswhen the premium will turn out
to be negative.
When the premium, when whenthese characteristics do not do
(14:30):
better than their counterparts,it's going to be cyclical.
You should expect that tohappen.
The, the stock market as a wholeis no different.
We see the same thing ininternational, in short term
periods of time, there's moreuncertainty there over long
periods of time, the more youextend that time horizon, the
more reliably that shows up.
And if you are investing inbroad market index funds, this
is basically what you're tryingto get.
(14:51):
You are just trying to get themarket factor and you're trying
to get it as cheaply, asinexpensive as possible.
and this is where most people'sknowledge, with the research
tends to end, right?
I think most people have anunderstanding here, but it's not
where the research ends cause aswe mentioned, this didn't
explain all the differences inreturn.
It didn't account for all thedifferences in return.
(15:12):
There were othercharacteristics.
There were, in the research, youmight hear it called anomalies
that weren't explained by thismodel.
There's something else going onthere.
There are other unique sourcesof risk and return that weren't
accounted for here.
And so as the research went on,eventually led to other
characteristics.
For example, the small factor.
So these smallest subset ofcompanies tended to outperform
(15:34):
the largest subset of companies,especially over long periods of
time.
The value factor is another one.
So value stocks, which arecheaper stocks relative to some
financial metric, like relativeto earnings or cashflow or, the
book equity on the balancesheet.
Those value stocks, thosecheaper stocks tended to
outperform the more expensivegrowth stocks, which, you know,
(16:00):
for example, a lot of the techstocks tend to be growth like
stocks.
The way I explain this toclients is that if, let's
imagine you're, you're trying tobuy an Optometry practice and
you're looking at two of'em.
And if you look at thefinancials, they have the exact
same revenue collected.
They have the exact same cost ofgets sold, the exact same
operating, expenses, the exactsame net profit, the exact same,
(16:23):
net income.
And the exact same cash flow,but one of them is priced much
more cheaply than the other one.
Which of those would you expectto have a higher return on your
dollars if you were to buy one?
Well, the right answer is, isthe cheaper one, because you're
able to buy the same cash flows,the same earnings at a cheaper
price.
But as we'll talk about later,that price is telling you
(16:43):
something.
There's something going on inthat practice that's leading to
a cheaper price, to cheapervaluation.
So the value factor is anotherone.
And putting these threetogether, 1990s, Eugene Fama,
Kenneth French, reallyinfluential and in fact Nobel
Prize winning, researchers, putthese together into a three
(17:05):
factor model, meaning there's aset of three characteristics
here that explain over 90% ofreturn differences between mixes
of investments, betweendifferent portfolios.
These are characteristics thatmost heavily explain what drives
markets.
These are some of the most, themost widely acknowledged ones,
but they're not the only ones.
(17:26):
The research continued, whateventually led to the
profitability factor or itscousin you might hear a, a
different one called quality,but the profitability factor,
meaning companies with higherprofitability tend to outperform
companies with lowerprofitability, as measured in
the research.
Turns out operating profits.
Very important.
The investment factor is anotherone.
(17:48):
meaning that the meaning thatbusinesses with high growth in
their assets on the balancesheet, meaning they're investing
really heavily into new assets,new equipment, things like that.
Those companies, especially inthe smallest subset of
companies, tended to performworse than companies that do not
have as quickly growing balancesheets.
and this is most noticeable insmaller companies,
(18:10):
interestingly.
and as you add those together,Gene Fama and Ken French put
together this sort of fivefactor model, which, which
explains again, even more of thereturn differences or what
drives markets.
And then one last one I'll justmention is momentum, which is
fascinating because what that isis that stocks that have done
well recently in the short term,tend to continue to doing well
(18:34):
in the short term.
And stocks that have done poorlyin the short term.
Tend to continue to do poorly inthe short term.
And this is fascinating becauseit's a purely short-term
behavioral phenomenon.
This is an an anomaly that isnot intuitive.
There's no real intuitiverisk-based explanation for why
it should exist, but it isstrongly documented in the data.
(18:57):
And so we have these keycharacteristics here that
explain the vast majority ofdifferences in in different
portfolios.
Mine to yours, yours to peers,but also what tend to drive
markets.
So we have the market factor,your investment in the stock
market as a whole.
And then within stocks, we havesmall companies, we have value
companies, and we haveprofitability with the addition
(19:21):
of honorable mentions,investment and momentum.
and as we talked about in thoseinitial, this initial criteria,
yes, they show up very clearlyin the data historically.
they are persistent, meaningthey show up across time as far
back as the data will let us go.
And just like we talked aboutwith stocks in short term
periods, there's a lot moreuncertainty there, but the
(19:43):
longer your time horizonextends, the more reliable those
premiums show up.
and what's interesting is thatthey show up at different times
value.
For example, the premium forvalue shows up at different
times from profitability.
When value's doing well,profitability doesn't tend to do
as well.
And when value's doing poorly,profitability balances it out.
(20:03):
And so you have another sort oflayer of diversification.
You're able to spread out yourdollars across unique sources of
risk and return and sort ofimprove the reliability of the
returns here.
And they are pervasive in thatthey show up across markets.
They show up in the UnitedStates, they show up in
developed countries outside ofthe United States, and they show
up in emerging markets.
And interestingly like we lookover the last 15 years as we've
(20:25):
talked about.
Large growth US companies havedone phenomenal, which means
that small value US companieshave not shown up.
That premium hasn't shown up inthe US in recent history.
However, that's really a USphenomenon outside of the United
States it's been a differentstory.
Those have been showing upoutside of the United States.
(20:48):
And so we've see thatinternational diversification,
global diversification canenhance the use of these
characteristics.
Or maybe it's the other wayaround.
Maybe it's these characteristicsenhance global diversification
and they are robust, meaningthey show up under different
definitions of each of those.
they're investible, meaning theycan actually be invested in, in
real life, in real life funds.
(21:08):
And the premium still existsafter costs.
with the exception of momentum.
It's debated whether momentumcan actually be invested in
specifically like as a specificstrategy or whether it's
something you invest inpassively, for example, by
simply being patient of when youdecide to sell something, if
it's having positive momentum orpatient if you're deciding to
(21:32):
buy something, if it's showingthat negative momentum.
So that's, that's the only onethat's sort of a little bit
different there, but they areinvestible.
They work in real life andthey're intuitive.
There is, as we'll talk about,there is an explanation or
rationale for why they shouldexist and why we should continue
to see them exist.
let's talk about why do thesefactors exist?
The reality is we can't knowwith certainty.
(21:54):
We know they show up quiteclearly in the data.
They do exist, but theexplanation can't be certain.
I mean, ultimately this is asclose to we can get as making
investing a science, butultimately economics, which is
finance, falls under economics.
It's a social science.
There's some art here.
There's some uncertainty.
And so one of the primaryexplanations that I think makes
(22:16):
the most sense is that these arecompensation for taking on
additional risk.
With stocks we know, forexample, quite intuitively that
businesses that owningbusinesses carry higher risk
than owning bonds, especially USgovernment bonds businesses can
legitimately, you can lose yourfull investment.
You know that if you own apractice, there is risk involved
(22:38):
with owning the business.
However, if you're a bondholder, you're at the top of
that list to get as much of yourcapital back in a bankruptcy as
you possibly can.
The time horizon with a stock isperpetual with a bond there's a
maturity date and with US bonds,with US treasuries, the United
States can just simply, canliterally create money to pay
its obligations.
And declines in stock prices,often follow periods where,
(23:03):
there's economic distress andyour income is expected to be
impacted, for example.
So the stock market carriesadditional risk relative to
bonds.
And you are getting compensatedfor taking on that risk.
Small companies, we canintuitively understand that
small companies have higherrisks than their largest
counterparts.
They're potentially moresusceptible to economic declines
(23:25):
or distress.
the cost for them to raise moneyto raise capital is going to be
higher in terms of lending, interms of.
You as an investor, you're gonnademand a higher return for those
to investing in those smallcompanies.
Value companies.
When we look at the researcharound what these value
companies look like, we see thatthey are cheap because they tend
to be companies in distress withhigh amounts of debt and have
(23:48):
high earnings risk.
they're much riskier than growthstocks in bad economic times.
They're very sensitive torecessions, but less risky
relative to growth stocks duringeconomic expansions.
So clearly risk.
When we look at what thesecompanies look like, risk is an
explanation that makes sense.
If you are going to invest inthese companies, you are wanting
(24:09):
to be compensated for taking onthat additional risk.
And then you and I as investorscan decide, okay, we have
different preferences.
What risks are we willing totake on?
How much of the stock market arewe willing to invest in versus
other things for our goals inour time horizon?
Are we willing to take on theseother risks in addition to that?
(24:32):
So we can, we can start to thinkabout, okay, what risks are we
willing to take on and can wespread out, diversify our
dollars across as many uniquesources of risk and return as
possible?
so risk is a part of that.
There's also behavioralexplanations when you think
about value, for example, evenprofitability.
this idea that investors preferthese exciting growth stocks.
(24:55):
Tech stocks, for example, are agood example of that investors
prefer to, to put dollars intothese exciting flashy growth
stocks, which tends to drive uptheir price and overreact to bad
news, which tends to lower theprice of value stocks.
So there might be a little bitof both there as we, as we think
about the explanations for that.
But I think there's a clear riskrationale for most of these
(25:15):
factors.
And if so, we should continuefor that to exist.
And one, one of the questionsthat also comes up is, well, you
know, Evon, you, you just talkedin the last episode about
markets being, for the most partefficient, setting fair prices
based on the information at handand, and how difficult it is to
outperform the market.
and that's true.
(25:36):
And it sounds like these factorsare trying to outperform the
market, which is also true.
Does this fly in the face ofmarket efficiency, right.
Of, of this whole concept andnot necessarily.
If it's a story of you beingcompensated for risk, we should
expect that to continue in anefficient market.
(25:57):
If, if markets are efficient andprices are set fairly well,
you're seeing fair prices.
The prices of a, of a company,just like the value of your
Optometry practice, tells yousomething about that business.
The price tells you somethingabout the risk and return you
expect with that business andhow certain or uncertain the
(26:21):
earnings are and the cash flowsare of that business.
And we wouldn't expect everybusiness to have the same exact
expected returns and expectedrisk.
Going back to that idea ofbuying two practices, one
practice is more cheaply thanthe other.
However, as you're going throughyour due diligence, you're
asking yourself, why is thispractice so cheap?
Something's going on in thatbusiness for that owner to be
(26:43):
willing to take on a lowerprice.
the owner is burned out and justneeds to get outta the business.
The patient demographics aredwindling.
the office and all the equipmentare outdated and are gonna need
to be replaced.
So essentially you're taking ona cold start anyways,
reputational risk, likesomething is going on in that
business.
And so the future earnings ofthat business are more
(27:06):
uncertain.
And so because of that, you asan investor, you're gonna demand
a lower price and a higherreturn, right?
So we, that's something we wouldexpect to continue.
Investors are gonna continue towant to be compensated for
taking on additional risk.
If it's a purely behavioralphenomenon or anomaly, well, not
so much.
You would expect that hedgefunds professional investors are
(27:28):
gonna get in there and sort ofarbitrage those away.
So many of these actually fitsquarely well in efficient
market, you would expect them tobe there and to continue.
another question that comes upis that, well, is this really
passive investing?
This sounds really active'causeI talked about again, in my last
conversation, why I believepassing investing still works.
(27:48):
And I think it really dependshow you define that.
if you define passive investingin the way, it's sort of been
defined in a lot of ways whereit's sort of these two check
boxes.
It's either an index approach,which is passive.
Or a non index approach.
And anything that isn't an indexfund is an active investment
approach.
So if you define it that way,well, it's not indexing, so it
(28:10):
is active.
And they sort of have to callthese, if you look at some of
the companies that provide ETFsaround this, for example, they
have to call them active ETFsbecause they're not indexed.
But in real life, that's notreally how passive And as active
investing work.
Really passive investing is sortof muddy.
And the way I define it is thatyou are investing in a broadly
(28:31):
diversified way based on aclear, transparent, and
systematic set of rules.
And not by intuition in tryingto pick the best individual
stocks or investments and tryingto time swings.
and if you think about indexfund, an index is just a list
with a set of rules that decideswho's in it.
and so this sort of factor basedapproach is taking what works
(28:54):
really well in indexing, whichis a broad, diversified, low
cost, tax efficient way ofinvesting with a set of rules
and taking it to another step.
And rather than investing in avery rigid index, they have more
discretion and flexibility andare changing the rules to weight
(29:15):
towards these othercharacteristics.
and so it's sort of an evolutionof index investing.
It's really, it's, it's takingwhat's great about index
investing to another step.
And we do need to be carefulbecause if we think about the
spectrum, there are, if we go tothe furthest end of the active
spectrum, there are activeinvestment funds that have value
funds that have x, y, Zcharacteristic.
(29:36):
And so those are thosetraditionally managed funds that
we would not expect tooutperform the benchmark as a
whole.
So something you need to keep inmind.
Another question that comes upis that do these factors still
work?
You know, everyone knows aboutthem.
The research is out.
Like are we still expecting themto work?
Because we know they show up inthe data before the research was
(29:57):
done.
But do they continue to show upafter the research is done and
everyone knows about it andactive hedge funds and
investment managers can takeadvantage of these
characteristics?
Well, what we find in theresearch is that post
publication of research, thesecharacteristics, these factors,
the premiums they give you stillexist.
(30:17):
They're still there, but theyare diminished.
We might expect them to besmaller than they were when
looking at the historicalresearch, but they do still
exist.
And it does highlight howimportant it is when you're,
when you're using funds thattake these approaches that they
both have a good approach toimplementation and cost and
efficiency.
Both of those are reallyimportant.
(30:39):
And there is a differencebetween underperformance and the
factors no longer working.
As we talked about earlier, weare expecting periods of
underperformance.
These characteristics show upcyclically, and we are not
expecting them to work at alltimes.
If we did, everyone would pileinto them and never own the
opposites.
(31:00):
There's a difference betweenperiods of un performance and
them permanently no longerworking.
That's really important.
so let's talk about thepractical applications, like how
do we use this stuff inpractice?
What do we do with thesefactors?
Well, one of the ways that thesefactors are used is that they
help us to understand whatexplains the returns of actively
managed mutual funds.
You know, if a manager has X, Y,Z outperformance against the
(31:23):
broad stock market as a whole,you can run it through these
factors.
You can see what explains thatoutperformance versus the market
as a whole?
Is it simply because they haveexposure to not only the stock
market but they have exposure tovalue characteristics and
smaller companies?
Because if that's the case, itdoesn't have anything to do with
(31:45):
their skill.
It's simply the fact that theyare owning more of those
characteristics.
And if it has nothing to do withtheir skill, there's no reason
for you to buy their fund andpay the extra fees for that.
You can invest in thosecharacteristics passively,
right?
So these characteristics helpshelp to explain the investment
performance of managers to seewhat's really due to their skill
(32:07):
versus simply to them havingexposure to certain
characteristics.
And, and we talked about in thelast episode, there's a
phenomenon of closet indexerswhere actively managed funds own
so many stocks that they lookpretty much like the index.
They're basically just mimickingthe index, either intentionally
or not, and you're paying thoseextra costs to simply get the
(32:28):
return of the broad market.
So those help us to understandwhere performance actually comes
from.
But another thing goes, goingback to our original question,
is that we can use thesecharacteristics to tilt towards,
to potentially improve theexpected outcomes for our
investments.
We can tilt towards thesecharacteristics.
(32:49):
We can own a little bit more ofthe smaller and and valuer and
more profitable companies thanyou might see in a global stock
market index fund.
And so how do we actuallyimplement this in our
portfolios?
Well, this is where, a podcastepisode like this really falls
short.
this is where really your owndue diligence or working
together with an advisor.
(33:10):
Implement this well, based onyour personal circumstances make
sense.
Some general guidelines to thinkabout are, are number one, I'm
not talking about here, makingreally highly concentrated bets
on any of these characteristics.
Like I, I'm not talking aboutgoing all in on small companies
or all in on value or all in onanything else.
The approach that I generallystart with when thinking about
(33:31):
investing, and you should thinkabout in your own due diligence,
is I'll start with the globalstock market index and as I have
evidence-based reasons to adjustaway from that, or if I have
really clear investorpreferences to adjust away from
that, that's when I'll start toadjust or tilt away from that.
And so I'm talking aboutstarting with owning everything,
(33:54):
but just tilting then towardsthese characteristics and away
from their counterparts, owningmore of things that are smaller
and cheaper or valuer and moreprofitable relative to what
you'd see in a total marketindex fund.
It's sort of like if you have anice tray and you put that ice
tray in flat in the freezer.
(34:14):
Well, that's like owning thewhole index in its exact
proportions.
Well, instead of what I'mtalking about is tilting the
water, so more of the water endsup in certain corners and less
of it ends up in the othercorners.
You're just tilting towardsthese characteristics.
And some fund families, willcreate funds that do this sort
(34:35):
of all in one.
Like it'll either have theglobal market and tilts towards
these characteristics on thatone fund.
Or they'll have a US fund and aninternational fund and emerging
market fund.
And within those, it'll tilttowards it.
So they'll take everythingthat's great about in index
funds and implement thisresearch within those funds.
And then you can add on to thatif you want to tilt even more.
(34:57):
So that's, that's one ofexample.
Some people will do a more of acore and satellite approach
where they'll have a broadmarket index fund and then use
like an individual small valuefund, an individual
international small value fundto get the tilts they want.
Reasonable minds can debate theimplementation.
it really comes down to whatmakes sense for you.
I would like you to think aboutstarting with owning everything
(35:19):
and then tilting towards allcharacteristics together.
And as I mentioned, there'shundreds of proposed factors out
there.
And the more that you're gonnaadd on, the more you're, you're
gonna tinker with.
And the more you start to tiltaway from just the market
portfolio, the more you need tobe sure that that's really gonna
be adding something to yourinvestments.
(35:40):
Above and beyond the cost andcomplexity of adding it.
And one more thing I'll addabout implementation is that
there are index funds that tryto invest in things like small
value.
There are index funds that tryto invest in, in these
characteristics, and a lot oftimes they're gonna be tempted
to go towards those because theyare the absolute cheapest.
But what I will say is that ifyou're no longer investing in a
(36:04):
broad whole market index, costsare not the only factor.
They're very important, butimplementation is hugely
important.
And so implementation's huge.
Something you wanna keep inmind.
So who are the good candidateswho should consider using an
approach like factor-basedinvesting?
Well, number one, it's someonethat has good understanding of
(36:25):
what these factors are.
You're working with a financialadvisor that has a good
understanding of these factors,and you have good expectations
of what to expect over time.
in addition, you can keep up oryour advisor keeps up with
research around thesecharacteristics and how mutual
funds and ETFs actuallyimplement them.
Both costs and implementationare really important here.
(36:47):
You have to have a really longtime horizon.
These are long-term investmentcharacteristics.
These are not short-termcharacteristics.
There are going to be periods oftime, even uncomfortably long
periods of time where thesepremiums don't show up.
Even stocks have underperformedbonds.
You're gonna see periods of timelike that, and you have to be
willing to stick with this forthe long term.
And have that ability to notabandon the strategy during
(37:10):
those periods ofunderperformance.
And we see this with 401(k)s,401k administrators are short
term thinkers.
I mean, they look at what's donewell recently, and make
adjustments to your fund lineupsbased on that.
And we've seen cases, especiallyin the US where these factor
funds in the US have been pulledoff and replaced with just broad
market index funds because ofthat short term performance and
(37:31):
clearly those administratorsdidn't understand the reason for
adding those to the fund lineupin the first place.
we've seen Roboadvisors, certainrobo platforms do the same
thing.
And so you have to have goodexpectations and have a
long-term time horizon.
And, and then lastly, those whojust appreciate evidence-based
approaches to investing, similarto evidence-based Optometry so
who shouldn't use factor-basedinvesting?
(37:52):
Who should stick with just broadmarket index funds?
Well, number one, if youprioritize ultimate simplicity
and if you just want to investin the broad market and keep it
super simple and not need tothink about anything else, you
don't wanna think about any ofthese definitions or research or
any of this stuff.
Broad market indexing can workwell for you.
(38:12):
I think that's the approach thatprobably makes the most sense
for you.
Number two, those who aren'table to handle looking different
than the market.
if you are constantlybenchmarking the day-to-day or
short-term interactions of yourinvestments versus some index
like the S&P 500 or the Russell3000, like if you're constantly
going to be comparing yourinvestments towards the index
(38:35):
and constantly be upset aboutthat, this probably isn't going
to make sense for you because ifyou're using these factors, you
are choosing to look differentthan the market.
And a big risk is that yourreturns are gonna look different
from the market.
There's going to be periods oftime where it will perform well
and times where it won't.
And you have to be able to justignore those differences.
(38:55):
and if that's gonna cause youconstant stress, then this
approach probably isn't gonnamake sense for you.
Just invest in the index.
And then number three, thosewith very short time horizons,
right?
Again, this is a long-terminvestment approach.
and if you have a very shorttime horizon, even the amount of
stocks that you own in generalis a really important decision.
So hopefully this is helpful.
I'm not sure if I'm going intotoo much weeds here.
(39:17):
This is sort of touching on ageneralized overview, some final
thoughts.
Factor investing isn't aboutabandoning passive investing
principles.
It's taking a lot of the sameresearch that leads to index
funds, to its furtherconclusions taking.
What's great about indexing.
Taking it to a next step.
But it takes a disciplinedlong-term approach.
(39:37):
One reason I wanted to talkabout this in episode just to
expose you to the idea thatthere is simply more to the
story than you typically hear.
Very often if you spend anyamount of times in these online
groups.
The idea of just investing inthe S&P 500 and nothing else is
commonly thrown out.
I just wanna expose you to the,to the facts, really to the data
that there is, there's more tothis story.
(40:00):
I consider that a very activeinvestment decision to only
invest in only the largestcompanies in only the United
States.
You are tilting, as we've talkedabout earlier, you're tilting
away from all other corporationsin all other countries as well
as the us.
And does that make sense fromthe data to own primarily the
(40:22):
growth largest companies in theUnited States.
As we've seen in thisconversation, well, not
necessarily, it worked well inthe last 15, 10, 15 years, but
historically, and especiallywhen you look across the globe,
that's not necessarily the case.
I just want to expose you to theidea that there's more to the
story here.
There are ways to improve,potential outcomes with your
(40:45):
investments in ways that are notfalling into the trap of trying
to be this really active trader.
And are based on evidence inacademic research and as much
of, of a scientific approach aswe can get.
So again, hopefully this helped.
Stay tuned.
I'll be tackling other commoninvestment topics I see come up
a lot, like, should youprioritize dividends in
(41:06):
investments?
Are individual bonds safer thanbond funds?
These are common questions andsometimes misconceptions that
I'd like to tackle here.
And check out the show notes allsorts of resources about this
topic that you can dive into forfurther learning.
If you have any questions,please reach out to me at
podcast@optometrywealth.Com, orschedule a time to chat.
if you don't want to hear aboutinvestments anymore and you find
(41:28):
this just isn't helpful, let meknow that as well.
I'd be interested to hear thattoo.
if you found the podcasthelpful, please leave a review,
share it with your peers.
And then lastly, if you wannalearn more about this, about tax
planning, about student loans,practice finances and more, you
definitely want to sign up forMy Weekly Eyes on the Money
Newsletter.
Well, I write about all of thesethings in a short form that you
(41:49):
can understand each and everyweek.
And with that, really appreciateyour time and attention.
We'll catch you on the nextepisode.
In the meantime, take care.
Hey everybody.
Welcome back to the OptometryMoney Podcast, where we're
helping ODs all over the countrymake better and better decisions
around their money, theircareers, and their practices.
I am your host, Evon Mendrin,Certified financial planning
practitioner and owner ofOptometry Wealth Advisors, an
independent financial planningfirm just for optometrist
(00:24):
nationwide.
And thank you so much forlistening.
Really appreciate your time andattention.
And on today's episode, I'mgoing to continue the sort of
investment series that I'm on,and we'll dive into an
optometrist guide toFactor-based investing.
In the last episode, episode134.
I dove into why Optometry shouldembrace passive investing and
(00:47):
index investing index funds, andI dove into the history and the
research and academic rootsbehind it and why we would
expect index investing to worknow and into the future, and
just why it is so unlikely thatactive investment managers,
either you or I, or professionalmanagers managing mutual funds
(01:09):
to outperform their broad marketindexes.
And if you haven't listened tothat one, highly recommend you
go back and listen to that onefirst before jumping into this
one.
Why does this matter?
Well, as optometrists oftenpractice owners managing both
practice and personal finances,you're taking the cash flow that
(01:29):
you get from your work and yourpractice.
And to first reinvest back intoyour practice and then into
investing in other assets.
It could be in your retirementaccounts at work, it could be
into other accounts, it could beinto real estate.
Whatever it is, you're takingthat cash flow and continuing
this habit over and over againof investing it into assets, and
(01:49):
as you do that, you need aninvestment approach that number
one, you understand.
That is expected to work overthe long term, meaning there's
evidence to suggest that itwould work over the long term
and that you can stick with.
And the question that comes outof that discussion around index
investing and broad marketinvesting like that is that,
(02:10):
well, can we improve portfoliosabove and beyond broad market
index funds?
Can we improve our investmentsbeyond just picking the global
stock market index fund that'savailable to us?
Without falling into the trap oftrying to be this really active
investor betting on individualstocks or trying to time the ups
and downs and the evidencepoints to yes, in fact, the same
(02:36):
academic work in fact, a lot ofthe same people that led to
index funds, and that explainswhy Index funds work continues
on.
And it builds on top of itself,which leads us down to the road
of factor based investing.
So what is a factor?
A factor is just a commoncharacteristic across a bunch of
(03:00):
investments.
As academic researchers havework to understand what really
drives markets.
And if we're, we're buying astock, we're buying the future
cash flows of these businesses,and they're trying to understand
or create models to explain howmuch we should be willing to pay
for those cash flows.
(03:21):
Given the risk and expectedreturn of that company, not much
different than if you're buyingan Optometry practice.
And then finally, what explainsthe differences in returns
between different broadlydiversified portfolios, meaning
your portfolio and your peersportfolio, meaning your, just
all of your investments combinedand my, my bundle of
(03:41):
investments, they're all gonnabehave differently.
So what explains the differencesin their behavior and their
returns.
And academic work has broughtout these certain factors or
characteristics are commonacross a bunch of investments
that help to explain variationsin returns.
And this isn't only ininvesting.
(04:01):
So what I, something I'velearned from a peer of mine, a
fellow advisor, is that theyhave factor models or groups of
characteristics, groups offactors for personalities.
There's even a five factor modelthat talks about these five
characteristics that primarilyexplain the differences in
personalities between differentpeople.
(04:22):
They're not the onlycharacteristics, but the
characteristics that have thestrongest ability to explain
differences in personalitiesbetween you or I, or, or a group
of us.
And so we find a similar thinghere in investing where research
has found that certain factorsor characteristics have been
shown to explain the risk andreturn of investments, and
(04:45):
importantly have been shown tohave a higher return over long
periods of time versus theircounterpart, meaning those
factors, those characteristicshave given a premium, an extra
return.
For investing in that group ofcharacteristics rather than
their counterparts.
So what is factor investing?
(05:05):
Well, factor investing istargeting or tilting toward
specific evidence-based stockcharacteristics we're we're
gonna be basically just talkingabout the stock market today
stock characteristics or factorsthat are tied to higher
long-term expected returns.
And what makes a reliablefactor?
(05:26):
there are, if you look at enoughpapers, there are hundreds of
factors proposed out there, alltrying to explain some factor
characteristic that provi leadsto a higher expected return.
sometimes you'll see thisreferred to as the factor zoo,
like everywhere you look,there's a new factor popping up
here or there to, to look at.
a lot of those though are shortterm anomalies that are based on
(05:49):
just pure randomness.
They're, they're not significantor are, or are so small that if
you actually try to invest inthem, just the cost of trading
in managing it would eat awayany of the extra returns.
So they're not really reliablecharacteristics.
there are, there is a small,really small group of commonly
(06:10):
held factors.
That have been shown to berobust and reliable, and there
are some criteria to figure outwhat is a, what makes a factor
reliable.
So in addition to actuallyshowing up in the data and
providing an excess return, wesee five common criteria for
(06:30):
robust, reliable factors.
And Andrew Berkin, who I've hadon the podcast and his
co-author, Larry Swedrow, who doa great job of describing this
in their book, Your CompleteGuide to Factor-Based Investing.
There are five criteria, andthose are, number one, it has to
be persistent, meaning thischaracteristic has to work
across time and differenteconomic regimes.
(06:51):
We can't be cherry picking aparticular five or 10 year
period across a hundred to 200years of of history.
It has to be persistent acrossperiods of time.
Number two, it has to bepervasive, meaning it has to
work across global markets andsectors, even different
categories of investments.
So it has to work acrossgeography.
(07:12):
It can't just work in oneparticular market and not work
anywhere else.
Number three, it has to berobust, meaning it has to hold
up to different definitions andmeasurement of that
characteristic.
We shouldn't have to torture andtease out a very, a very
specific way to describe it inorder for it to work.
Number four, it has to beinvestible.
(07:33):
Meaning that even if it shows upon paper, it ha you have to be
able to actually implement it inreal life.
Cost effectively, and it stillhas to work after costs.
And then lastly, it has to beintuitive.
It has to make sense.
There has to be some logicaleconomic explanation for this.
(07:54):
It can't simply be, Hey, youknow, all stocks that start with
T tend to do better than stocksthat start with S That might
show up in the data, but there'sno economic rationale for why we
should expect that to continue.
And so persistent, pervasive,robust, investible and
intuitive.
You might look at, I don't know,like that diagnostic tool in the
(08:15):
same way, it has to workconsistently.
It has to work across patientpopulations.
You have, it has to work usingdifferent measurement
approaches.
It has to be practical toactually use in your clinic.
And have a clear scientificrationale.
Maybe you have a similarframework for looking at things
like that.
And so if it meets thesecriteria, it's likely not to be
(08:36):
just data mining or just purerandomness, but reliably and
robust something we can expectto continue into the future.
So what are these factors thatwe're talking about?
What are the characteristics?
Well, there is a core set ofthree to five or six
characteristics that are notonly show up clearly in the data
historically, but are widelyaccepted as reliable, robust
(08:59):
characteristics.
And the first one is the marketfactor.
And this is simply your exposureto the stock market as a whole.
The, the entirety of the stockmarket is itself a
characteristic that explains thereturns of a portfolio.
And the premium that it givesyou is often defined as the
return of the stock market minusthe return of short-term
(09:22):
treasury bills, US treasurybills, which are sort of the
risk-free return, right?
There's, there's essentially norisk for those short-term
treasuries.
And so the differences there isthe premium, the extra returns
that you either got historicallyor would accept for taking on
the risk of investing in stocks.
It's often called the equityrisk premium.
(09:44):
This is what you're demanding asan investor for taking on risk.
And this goes back to, 1960s,Bill Sharp's Capital Asset
Pricing Model, which you mayhave heard of if you've taken
any Intro to finance classes.
Or MBA courses, even though themodel itself doesn't work in
real life, it, it's still oftentaught in MBA courses.
And this is also where thatjargon word, if you ever heard
(10:06):
the jargon word beta, this iswhere beta comes from.
It's a measure of something'svolatility relative to the stock
market as a whole.
or if someone says, Hey, you're,you're just getting beta, that
just means you're gettingexposure to the market as a
whole.
And this is really importantresearch, sort of putting,
putting on paper, thisrelationship between risk and
(10:29):
return.
Before this, you know, you canimagine any stockbroker at the
time, anytime there was positiveperformance in client accounts,
they're taking credit for it.
It's, this is, hey, this istheir, their unique skill,
right?
This is their skill that'sproviding that return.
And then research like thiscomes along and says, well, no,
not necessarily.
In fact, all you're seeing thereis investors getting compensated
(10:53):
for investing in stocks as awhole.
This may have nothing to do atall with the skill of the
manager, but this is simply thereturn that clients are getting,
that investors are getting forinvesting broadly in the market
as a whole.
And if stocks or some manager isexpected to have higher returns
in the market, then they're onlydoing that by taking on more
(11:14):
risk.
Not necessarily because of theirskill.
And so the amount of stocks youown, really your exposure to the
stock market is able to explain,statistically about two thirds
or about 66% of the differencesin returns between two mixes of
investments, my mix ofinvestments versus your mix of
investments.
This has a lot of explanatorypower.
(11:36):
Which sort of highlights howimportant of a decision it is
based on your time horizon basedon your investment goals and
just your ability to acceptinvestment risk, how important
of a decision it is, how muchstocks you're gonna have
relative to other things likebonds, and how that changes over
your lifetime as you get closerand closer to needing to use the
(11:57):
funds because this will explainthe majority of your returns and
risk over your, over yourlifetime.
and this is where most people'sknowledge tends to end.
I mean, most of you probablyintuity have an understanding
that yeah, the stock market isriskier than government bonds.
We're, we're expecting becauseof that, to be compensated with
higher returns.
they're not guaranteed.
(12:19):
They're definitely notguaranteed.
In fact, we've seen long years,you know, if we look back at
rolling periods historically.
looking back, for example, inthe US from 1926 through 2024,
over one year periods, thispremium showed up, meaning US
stocks had a higher return thanUS treasuries only 70% of the
(12:40):
time.
Now that's the majority ofyears, but there are still
plenty of years where stocks inthe US did not outperform US
treasuries.
And if you look over five yearperiods of time, that extended
to, 79%, 10 year periods oftime, it's 86%, 15 year periods,
96%.
And then the longer you extendthat time horizon, the more
(13:02):
reliably stocks haveoutperformed government bonds.
But there are long periods oftime where you see that that
premium, that excess returndoesn't show up and it can be
uncomfortably long periods oftime.
So, for example, in the US welook back the last 15 years at
how well US companies didrelative to the rest of the
(13:23):
world and especially the largestUS companies, the largest tech
growth US companies.
and we kind of expect that tocontinue on for the rest of our
lifetimes, but that's notnecessarily the case.
What we do there is we forgetabout the decade before because
the early two thousands, therewas an entire 10 year period
where US stocks did notoutperform government bonds, in
(13:46):
fact provided a slightlynegative return for a full 10
year period for a full decade.
That's a long time, and you haveto be willing to accept that
risk to go through that in orderto get that potential, that
expected higher return.
It's not guaranteed.
There are periods of time whereyou're not gonna see that.
(14:07):
Berkin and Swedrow in that bookI'd mentioned earlier, put it
perfectly well, they say"theimportant takeaways that if you
want to earn the expected butnot guaranteed premium from a
factor, you must be willing toaccept the risks that there will
almost certainly be long periodswhen the premium will turn out
to be negative.
When the premium, when whenthese characteristics do not do
(14:30):
better than their counterparts,it's going to be cyclical.
You should expect that tohappen.
The, the stock market as a wholeis no different.
We see the same thing ininternational, in short term
periods of time, there's moreuncertainty there over long
periods of time, the more youextend that time horizon, the
more reliably that shows up.
And if you are investing inbroad market index funds, this
is basically what you're tryingto get.
(14:51):
You are just trying to get themarket factor and you're trying
to get it as cheaply, asinexpensive as possible.
and this is where most people'sknowledge, with the research
tends to end, right?
I think most people have anunderstanding here, but it's not
where the research ends cause aswe mentioned, this didn't
explain all the differences inreturn.
It didn't account for all thedifferences in return.
(15:12):
There were othercharacteristics.
There were, in the research, youmight hear it called anomalies
that weren't explained by thismodel.
There's something else going onthere.
There are other unique sourcesof risk and return that weren't
accounted for here.
And so as the research went on,eventually led to other
characteristics.
For example, the small factor.
So these smallest subset ofcompanies tended to outperform
(15:34):
the largest subset of companies,especially over long periods of
time.
The value factor is another one.
So value stocks, which arecheaper stocks relative to some
financial metric, like relativeto earnings or cashflow or, the
book equity on the balancesheet.
Those value stocks, thosecheaper stocks tended to
outperform the more expensivegrowth stocks, which, you know,
(16:00):
for example, a lot of the techstocks tend to be growth like
stocks.
The way I explain this toclients is that if, let's
imagine you're, you're trying tobuy an Optometry practice and
you're looking at two of'em.
And if you look at thefinancials, they have the exact
same revenue collected.
They have the exact same cost ofgets sold, the exact same
operating, expenses, the exactsame net profit, the exact same,
(16:23):
net income.
And the exact same cash flow,but one of them is priced much
more cheaply than the other one.
Which of those would you expectto have a higher return on your
dollars if you were to buy one?
Well, the right answer is, isthe cheaper one, because you're
able to buy the same cash flows,the same earnings at a cheaper
price.
But as we'll talk about later,that price is telling you
(16:43):
something.
There's something going on inthat practice that's leading to
a cheaper price, to cheapervaluation.
So the value factor is anotherone.
And putting these threetogether, 1990s, Eugene Fama,
Kenneth French, reallyinfluential and in fact Nobel
Prize winning, researchers, putthese together into a three
(17:05):
factor model, meaning there's aset of three characteristics
here that explain over 90% ofreturn differences between mixes
of investments, betweendifferent portfolios.
These are characteristics thatmost heavily explain what drives
markets.
These are some of the most, themost widely acknowledged ones,
but they're not the only ones.
(17:26):
The research continued, whateventually led to the
profitability factor or itscousin you might hear a, a
different one called quality,but the profitability factor,
meaning companies with higherprofitability tend to outperform
companies with lowerprofitability, as measured in
the research.
Turns out operating profits.
Very important.
The investment factor is anotherone.
(17:48):
meaning that the meaning thatbusinesses with high growth in
their assets on the balancesheet, meaning they're investing
really heavily into new assets,new equipment, things like that.
Those companies, especially inthe smallest subset of
companies, tended to performworse than companies that do not
have as quickly growing balancesheets.
and this is most noticeable insmaller companies,
(18:10):
interestingly.
and as you add those together,Gene Fama and Ken French put
together this sort of fivefactor model, which, which
explains again, even more of thereturn differences or what
drives markets.
And then one last one I'll justmention is momentum, which is
fascinating because what that isis that stocks that have done
well recently in the short term,tend to continue to doing well
(18:34):
in the short term.
And stocks that have done poorlyin the short term.
Tend to continue to do poorly inthe short term.
And this is fascinating becauseit's a purely short-term
behavioral phenomenon.
This is an an anomaly that isnot intuitive.
There's no real intuitiverisk-based explanation for why
it should exist, but it isstrongly documented in the data.
(18:57):
And so we have these keycharacteristics here that
explain the vast majority ofdifferences in in different
portfolios.
Mine to yours, yours to peers,but also what tend to drive
markets.
So we have the market factor,your investment in the stock
market as a whole.
And then within stocks, we havesmall companies, we have value
companies, and we haveprofitability with the addition
(19:21):
of honorable mentions,investment and momentum.
and as we talked about in thoseinitial, this initial criteria,
yes, they show up very clearlyin the data historically.
they are persistent, meaningthey show up across time as far
back as the data will let us go.
And just like we talked aboutwith stocks in short term
periods, there's a lot moreuncertainty there, but the
(19:43):
longer your time horizonextends, the more reliable those
premiums show up.
and what's interesting is thatthey show up at different times
value.
For example, the premium forvalue shows up at different
times from profitability.
When value's doing well,profitability doesn't tend to do
as well.
And when value's doing poorly,profitability balances it out.
(20:03):
And so you have another sort oflayer of diversification.
You're able to spread out yourdollars across unique sources of
risk and return and sort ofimprove the reliability of the
returns here.
And they are pervasive in thatthey show up across markets.
They show up in the UnitedStates, they show up in
developed countries outside ofthe United States, and they show
up in emerging markets.
And interestingly like we lookover the last 15 years as we've
(20:25):
talked about.
Large growth US companies havedone phenomenal, which means
that small value US companieshave not shown up.
That premium hasn't shown up inthe US in recent history.
However, that's really a USphenomenon outside of the United
States it's been a differentstory.
Those have been showing upoutside of the United States.
(20:48):
And so we've see thatinternational diversification,
global diversification canenhance the use of these
characteristics.
Or maybe it's the other wayaround.
Maybe it's these characteristicsenhance global diversification
and they are robust, meaningthey show up under different
definitions of each of those.
they're investible, meaning theycan actually be invested in, in
real life, in real life funds.
(21:08):
And the premium still existsafter costs.
with the exception of momentum.
It's debated whether momentumcan actually be invested in
specifically like as a specificstrategy or whether it's
something you invest inpassively, for example, by
simply being patient of when youdecide to sell something, if
it's having positive momentum orpatient if you're deciding to
(21:32):
buy something, if it's showingthat negative momentum.
So that's, that's the only onethat's sort of a little bit
different there, but they areinvestible.
They work in real life andthey're intuitive.
There is, as we'll talk about,there is an explanation or
rationale for why they shouldexist and why we should continue
to see them exist.
let's talk about why do thesefactors exist?
The reality is we can't knowwith certainty.
(21:54):
We know they show up quiteclearly in the data.
They do exist, but theexplanation can't be certain.
I mean, ultimately this is asclose to we can get as making
investing a science, butultimately economics, which is
finance, falls under economics.
It's a social science.
There's some art here.
There's some uncertainty.
And so one of the primaryexplanations that I think makes
(22:16):
the most sense is that these arecompensation for taking on
additional risk.
With stocks we know, forexample, quite intuitively that
businesses that owningbusinesses carry higher risk
than owning bonds, especially USgovernment bonds businesses can
legitimately, you can lose yourfull investment.
You know that if you own apractice, there is risk involved
(22:38):
with owning the business.
However, if you're a bondholder, you're at the top of
that list to get as much of yourcapital back in a bankruptcy as
you possibly can.
The time horizon with a stock isperpetual with a bond there's a
maturity date and with US bonds,with US treasuries, the United
States can just simply, canliterally create money to pay
its obligations.
And declines in stock prices,often follow periods where,
(23:03):
there's economic distress andyour income is expected to be
impacted, for example.
So the stock market carriesadditional risk relative to
bonds.
And you are getting compensatedfor taking on that risk.
Small companies, we canintuitively understand that
small companies have higherrisks than their largest
counterparts.
They're potentially moresusceptible to economic declines
(23:25):
or distress.
the cost for them to raise moneyto raise capital is going to be
higher in terms of lending, interms of.
You as an investor, you're gonnademand a higher return for those
to investing in those smallcompanies.
Value companies.
When we look at the researcharound what these value
companies look like, we see thatthey are cheap because they tend
to be companies in distress withhigh amounts of debt and have
(23:48):
high earnings risk.
they're much riskier than growthstocks in bad economic times.
They're very sensitive torecessions, but less risky
relative to growth stocks duringeconomic expansions.
So clearly risk.
When we look at what thesecompanies look like, risk is an
explanation that makes sense.
If you are going to invest inthese companies, you are wanting
(24:09):
to be compensated for taking onthat additional risk.
And then you and I as investorscan decide, okay, we have
different preferences.
What risks are we willing totake on?
How much of the stock market arewe willing to invest in versus
other things for our goals inour time horizon?
Are we willing to take on theseother risks in addition to that?
(24:32):
So we can, we can start to thinkabout, okay, what risks are we
willing to take on and can wespread out, diversify our
dollars across as many uniquesources of risk and return as
possible?
so risk is a part of that.
There's also behavioralexplanations when you think
about value, for example, evenprofitability.
this idea that investors preferthese exciting growth stocks.
(24:55):
Tech stocks, for example, are agood example of that investors
prefer to, to put dollars intothese exciting flashy growth
stocks, which tends to drive uptheir price and overreact to bad
news, which tends to lower theprice of value stocks.
So there might be a little bitof both there as we, as we think
about the explanations for that.
But I think there's a clear riskrationale for most of these
(25:15):
factors.
And if so, we should continuefor that to exist.
And one, one of the questionsthat also comes up is, well, you
know, Evon, you, you just talkedin the last episode about
markets being, for the most partefficient, setting fair prices
based on the information at handand, and how difficult it is to
outperform the market.
and that's true.
(25:36):
And it sounds like these factorsare trying to outperform the
market, which is also true.
Does this fly in the face ofmarket efficiency, right.
Of, of this whole concept andnot necessarily.
If it's a story of you beingcompensated for risk, we should
expect that to continue in anefficient market.
(25:57):
If, if markets are efficient andprices are set fairly well,
you're seeing fair prices.
The prices of a, of a company,just like the value of your
Optometry practice, tells yousomething about that business.
The price tells you somethingabout the risk and return you
expect with that business andhow certain or uncertain the
(26:21):
earnings are and the cash flowsare of that business.
And we wouldn't expect everybusiness to have the same exact
expected returns and expectedrisk.
Going back to that idea ofbuying two practices, one
practice is more cheaply thanthe other.
However, as you're going throughyour due diligence, you're
asking yourself, why is thispractice so cheap?
Something's going on in thatbusiness for that owner to be
(26:43):
willing to take on a lowerprice.
the owner is burned out and justneeds to get outta the business.
The patient demographics aredwindling.
the office and all the equipmentare outdated and are gonna need
to be replaced.
So essentially you're taking ona cold start anyways,
reputational risk, likesomething is going on in that
business.
And so the future earnings ofthat business are more
(27:06):
uncertain.
And so because of that, you asan investor, you're gonna demand
a lower price and a higherreturn, right?
So we, that's something we wouldexpect to continue.
Investors are gonna continue towant to be compensated for
taking on additional risk.
If it's a purely behavioralphenomenon or anomaly, well, not
so much.
You would expect that hedgefunds professional investors are
(27:28):
gonna get in there and sort ofarbitrage those away.
So many of these actually fitsquarely well in efficient
market, you would expect them tobe there and to continue.
another question that comes upis that, well, is this really
passive investing?
This sounds really active'causeI talked about again, in my last
conversation, why I believepassing investing still works.
(27:48):
And I think it really dependshow you define that.
if you define passive investingin the way, it's sort of been
defined in a lot of ways whereit's sort of these two check
boxes.
It's either an index approach,which is passive.
Or a non index approach.
And anything that isn't an indexfund is an active investment
approach.
So if you define it that way,well, it's not indexing, so it
(28:10):
is active.
And they sort of have to callthese, if you look at some of
the companies that provide ETFsaround this, for example, they
have to call them active ETFsbecause they're not indexed.
But in real life, that's notreally how passive And as active
investing work.
Really passive investing is sortof muddy.
And the way I define it is thatyou are investing in a broadly
(28:31):
diversified way based on aclear, transparent, and
systematic set of rules.
And not by intuition in tryingto pick the best individual
stocks or investments and tryingto time swings.
and if you think about indexfund, an index is just a list
with a set of rules that decideswho's in it.
and so this sort of factor basedapproach is taking what works
(28:54):
really well in indexing, whichis a broad, diversified, low
cost, tax efficient way ofinvesting with a set of rules
and taking it to another step.
And rather than investing in avery rigid index, they have more
discretion and flexibility andare changing the rules to weight
(29:15):
towards these othercharacteristics.
and so it's sort of an evolutionof index investing.
It's really, it's, it's takingwhat's great about index
investing to another step.
And we do need to be carefulbecause if we think about the
spectrum, there are, if we go tothe furthest end of the active
spectrum, there are activeinvestment funds that have value
funds that have x, y, Zcharacteristic.
(29:36):
And so those are thosetraditionally managed funds that
we would not expect tooutperform the benchmark as a
whole.
So something you need to keep inmind.
Another question that comes upis that do these factors still
work?
You know, everyone knows aboutthem.
The research is out.
Like are we still expecting themto work?
Because we know they show up inthe data before the research was
(29:57):
done.
But do they continue to show upafter the research is done and
everyone knows about it andactive hedge funds and
investment managers can takeadvantage of these
characteristics?
Well, what we find in theresearch is that post
publication of research, thesecharacteristics, these factors,
the premiums they give you stillexist.
(30:17):
They're still there, but theyare diminished.
We might expect them to besmaller than they were when
looking at the historicalresearch, but they do still
exist.
And it does highlight howimportant it is when you're,
when you're using funds thattake these approaches that they
both have a good approach toimplementation and cost and
efficiency.
Both of those are reallyimportant.
(30:39):
And there is a differencebetween underperformance and the
factors no longer working.
As we talked about earlier, weare expecting periods of
underperformance.
These characteristics show upcyclically, and we are not
expecting them to work at alltimes.
If we did, everyone would pileinto them and never own the
opposites.
(31:00):
There's a difference betweenperiods of un performance and
them permanently no longerworking.
That's really important.
so let's talk about thepractical applications, like how
do we use this stuff inpractice?
What do we do with thesefactors?
Well, one of the ways that thesefactors are used is that they
help us to understand whatexplains the returns of actively
managed mutual funds.
You know, if a manager has X, Y,Z outperformance against the
(31:23):
broad stock market as a whole,you can run it through these
factors.
You can see what explains thatoutperformance versus the market
as a whole?
Is it simply because they haveexposure to not only the stock
market but they have exposure tovalue characteristics and
smaller companies?
Because if that's the case, itdoesn't have anything to do with
(31:45):
their skill.
It's simply the fact that theyare owning more of those
characteristics.
And if it has nothing to do withtheir skill, there's no reason
for you to buy their fund andpay the extra fees for that.
You can invest in thosecharacteristics passively,
right?
So these characteristics helpshelp to explain the investment
performance of managers to seewhat's really due to their skill
(32:07):
versus simply to them havingexposure to certain
characteristics.
And, and we talked about in thelast episode, there's a
phenomenon of closet indexerswhere actively managed funds own
so many stocks that they lookpretty much like the index.
They're basically just mimickingthe index, either intentionally
or not, and you're paying thoseextra costs to simply get the
(32:28):
return of the broad market.
So those help us to understandwhere performance actually comes
from.
But another thing goes, goingback to our original question,
is that we can use thesecharacteristics to tilt towards,
to potentially improve theexpected outcomes for our
investments.
We can tilt towards thesecharacteristics.
(32:49):
We can own a little bit more ofthe smaller and and valuer and
more profitable companies thanyou might see in a global stock
market index fund.
And so how do we actuallyimplement this in our
portfolios?
Well, this is where, a podcastepisode like this really falls
short.
this is where really your owndue diligence or working
together with an advisor.
(33:10):
Implement this well, based onyour personal circumstances make
sense.
Some general guidelines to thinkabout are, are number one, I'm
not talking about here, makingreally highly concentrated bets
on any of these characteristics.
Like I, I'm not talking aboutgoing all in on small companies
or all in on value or all in onanything else.
The approach that I generallystart with when thinking about
(33:31):
investing, and you should thinkabout in your own due diligence,
is I'll start with the globalstock market index and as I have
evidence-based reasons to adjustaway from that, or if I have
really clear investorpreferences to adjust away from
that, that's when I'll start toadjust or tilt away from that.
And so I'm talking aboutstarting with owning everything,
(33:54):
but just tilting then towardsthese characteristics and away
from their counterparts, owningmore of things that are smaller
and cheaper or valuer and moreprofitable relative to what
you'd see in a total marketindex fund.
It's sort of like if you have anice tray and you put that ice
tray in flat in the freezer.
(34:14):
Well, that's like owning thewhole index in its exact
proportions.
Well, instead of what I'mtalking about is tilting the
water, so more of the water endsup in certain corners and less
of it ends up in the othercorners.
You're just tilting towardsthese characteristics.
And some fund families, willcreate funds that do this sort
(34:35):
of all in one.
Like it'll either have theglobal market and tilts towards
these characteristics on thatone fund.
Or they'll have a US fund and aninternational fund and emerging
market fund.
And within those, it'll tilttowards it.
So they'll take everythingthat's great about in index
funds and implement thisresearch within those funds.
And then you can add on to thatif you want to tilt even more.
(34:57):
So that's, that's one ofexample.
Some people will do a more of acore and satellite approach
where they'll have a broadmarket index fund and then use
like an individual small valuefund, an individual
international small value fundto get the tilts they want.
Reasonable minds can debate theimplementation.
it really comes down to whatmakes sense for you.
I would like you to think aboutstarting with owning everything
(35:19):
and then tilting towards allcharacteristics together.
And as I mentioned, there'shundreds of proposed factors out
there.
And the more that you're gonnaadd on, the more you're, you're
gonna tinker with.
And the more you start to tiltaway from just the market
portfolio, the more you need tobe sure that that's really gonna
be adding something to yourinvestments.
(35:40):
Above and beyond the cost andcomplexity of adding it.
And one more thing I'll addabout implementation is that
there are index funds that tryto invest in things like small
value.
There are index funds that tryto invest in, in these
characteristics, and a lot oftimes they're gonna be tempted
to go towards those because theyare the absolute cheapest.
But what I will say is that ifyou're no longer investing in a
(36:04):
broad whole market index, costsare not the only factor.
They're very important, butimplementation is hugely
important.
And so implementation's huge.
Something you wanna keep inmind.
So who are the good candidateswho should consider using an
approach like factor-basedinvesting?
Well, number one, it's someonethat has good understanding of
(36:25):
what these factors are.
You're working with a financialadvisor that has a good
understanding of these factors,and you have good expectations
of what to expect over time.
in addition, you can keep up oryour advisor keeps up with
research around thesecharacteristics and how mutual
funds and ETFs actuallyimplement them.
Both costs and implementationare really important here.
(36:47):
You have to have a really longtime horizon.
These are long-term investmentcharacteristics.
These are not short-termcharacteristics.
There are going to be periods oftime, even uncomfortably long
periods of time where thesepremiums don't show up.
Even stocks have underperformedbonds.
You're gonna see periods of timelike that, and you have to be
willing to stick with this forthe long term.
And have that ability to notabandon the strategy during
(37:10):
those periods ofunderperformance.
And we see this with 401(k)s,401k administrators are short
term thinkers.
I mean, they look at what's donewell recently, and make
adjustments to your fund lineupsbased on that.
And we've seen cases, especiallyin the US where these factor
funds in the US have been pulledoff and replaced with just broad
market index funds because ofthat short term performance and
(37:31):
clearly those administratorsdidn't understand the reason for
adding those to the fund lineupin the first place.
we've seen Roboadvisors, certainrobo platforms do the same
thing.
And so you have to have goodexpectations and have a
long-term time horizon.
And, and then lastly, those whojust appreciate evidence-based
approaches to investing, similarto evidence-based Optometry so
who shouldn't use factor-basedinvesting?
(37:52):
Who should stick with just broadmarket index funds?
Well, number one, if youprioritize ultimate simplicity
and if you just want to investin the broad market and keep it
super simple and not need tothink about anything else, you
don't wanna think about any ofthese definitions or research or
any of this stuff.
Broad market indexing can workwell for you.
(38:12):
I think that's the approach thatprobably makes the most sense
for you.
Number two, those who aren'table to handle looking different
than the market.
if you are constantlybenchmarking the day-to-day or
short-term interactions of yourinvestments versus some index
like the S&P 500 or the Russell3000, like if you're constantly
going to be comparing yourinvestments towards the index
(38:35):
and constantly be upset aboutthat, this probably isn't going
to make sense for you because ifyou're using these factors, you
are choosing to look differentthan the market.
And a big risk is that yourreturns are gonna look different
from the market.
There's going to be periods oftime where it will perform well
and times where it won't.
And you have to be able to justignore those differences.
(38:55):
and if that's gonna cause youconstant stress, then this
approach probably isn't gonnamake sense for you.
Just invest in the index.
And then number three, thosewith very short time horizons,
right?
Again, this is a long-terminvestment approach.
and if you have a very shorttime horizon, even the amount of
stocks that you own in generalis a really important decision.
So hopefully this is helpful.
I'm not sure if I'm going intotoo much weeds here.
(39:17):
This is sort of touching on ageneralized overview, some final
thoughts.
Factor investing isn't aboutabandoning passive investing
principles.
It's taking a lot of the sameresearch that leads to index
funds, to its furtherconclusions taking.
What's great about indexing.
Taking it to a next step.
But it takes a disciplinedlong-term approach.
(39:37):
One reason I wanted to talkabout this in episode just to
expose you to the idea thatthere is simply more to the
story than you typically hear.
Very often if you spend anyamount of times in these online
groups.
The idea of just investing inthe S&P 500 and nothing else is
commonly thrown out.
I just wanna expose you to the,to the facts, really to the data
that there is, there's more tothis story.
(40:00):
I consider that a very activeinvestment decision to only
invest in only the largestcompanies in only the United
States.
You are tilting, as we've talkedabout earlier, you're tilting
away from all other corporationsin all other countries as well
as the us.
And does that make sense fromthe data to own primarily the
(40:22):
growth largest companies in theUnited States.
As we've seen in thisconversation, well, not
necessarily, it worked well inthe last 15, 10, 15 years, but
historically, and especiallywhen you look across the globe,
that's not necessarily the case.
I just want to expose you to theidea that there's more to the
story here.
There are ways to improve,potential outcomes with your
(40:45):
investments in ways that are notfalling into the trap of trying
to be this really active trader.
And are based on evidence inacademic research and as much
of, of a scientific approach aswe can get.
So again, hopefully this helped.
Stay tuned.
I'll be tackling other commoninvestment topics I see come up
a lot, like, should youprioritize dividends in
(41:06):
investments?
Are individual bonds safer thanbond funds?
These are common questions andsometimes misconceptions that
I'd like to tackle here.
And check out the show notes allsorts of resources about this
topic that you can dive into forfurther learning.
If you have any questions,please reach out to me at
podcast@optometrywealth.Com, orschedule a time to chat.
if you don't want to hear aboutinvestments anymore and you find
(41:28):
this just isn't helpful, let meknow that as well.
I'd be interested to hear thattoo.
if you found the podcasthelpful, please leave a review,
share it with your peers.
And then lastly, if you wannalearn more about this, about tax
planning, about student loans,practice finances and more, you
definitely want to sign up forMy Weekly Eyes on the Money
Newsletter.
Well, I write about all of thesethings in a short form that you
(41:49):
can understand each and everyweek.
And with that, really appreciateyour time and attention.
We'll catch you on the nextepisode.
In the meantime, take care.
Popular Podcasts
Dateline NBC
Current and classic episodes, featuring compelling true-crime mysteries, powerful documentaries and in-depth investigations. Follow now to get the latest episodes of Dateline NBC completely free, or subscribe to Dateline Premium for ad-free listening and exclusive bonus content: DatelinePremium.com
24/7 News: The Latest
The latest news in 4 minutes updated every hour, every day.
Therapy Gecko
An unlicensed lizard psychologist travels the universe talking to strangers about absolutely nothing. TO CALL THE GECKO: follow me on https://www.twitch.tv/lyleforever to get a notification for when I am taking calls. I am usually live Mondays, Wednesdays, and Fridays but lately a lot of other times too. I am a gecko.