It’s the holy grail of investing – the ability of an investor to consistently beat market returns.
Depending on who you ask, beating the market is either an exercise in futility or entirely possible with the right stock picking skills or active fund manager.
There’s no shortage of opinions out there!
However, a look at historical data indicates that the odds are stacked against your favour. Over 90% of actively managed funds fail to beat market returns in a given year.
If even the market professional has so much trouble beating market returns, surely a do-it-yourself investor is better off with a simple passive index investing approach?
The answer: (potentially) yes and no.
If we’re comparing index investing with stock picking and other forms of active trading, then statistically speaking you are quite unlikely to beat market returns, especially over the long-term. This is in large part due to the skewness of stock returns – that is, a majority of the market’s positive performance is explained by a small fraction of total stocks.
With that said, how can we beat market returns?
In order to better understand how we could potentially beat market returns over the long term, we first need to take a closer look at the relationship between risk and reward.
Not All Risk Is Made Equal
You’ve probably heard the following saying: the greater the risk, the greater the reward.
In the investing world, this only holds for a certain type of risk – this type of risk is known as compensated risk. In particular, if you want greater expected returns, you’ll need to take on additional compensated risk. Market risk is a type of compensated risk.
On the flip side, taking on uncompensated risk means taking on additional risk without greater expected returns. Stock picking is an example of uncompensated risk. The problem with such strategies is that the investor loses out on the benefits of diversification, which is often referred to as the free lunch of the investing world.
With that being said, how can one increase expected returns above and beyond market returns?
As we’ve just discussed, in order to have the best chance of beating the market, an investor must take on additional compensated risk. There are two approaches we can use to take on additional compensated risk while also maintaining a passive index-based approach. These are factor investing and using leverage.
Evidence-Based Methods to Beat Market Returns
- Factor Investing
- Investing with Leverage
What exactly is factor investing?
I believe that all index investors should have an understanding of what factor investing is, as the research has shown some compelling results.
The word “factor” may make the strategy sound complex and daunting, but the fundamental idea is quite straightforward – which is that stocks with certain shared characteristics have been shown to outperform those with the opposite characteristic.
Typically, an index investor who “buys the whole market” makes market returns. By market returns, I am referring to the returns you would make from investing only in index funds that are weighted by market capitalization. In a market cap fund, the weighting of each company within the fund is based on the company’s market value. Examples include ETFs like VOO or VFV that track the S&P 500 index.
By investing in a market cap weighted portfolio, you are taking on the single risk factor of market risk. You are compensated for taking on this risk with an equity premium, which is the excess returns of investing in the market over the alternative option of investing in a risk-free asset such as treasury bills.
Investing in a market cap weighted portfolio is where most index investors stop. Indeed, there is a valid argument that a market cap weighted portfolio is a fitting tradeoff between time spent, complexity, and risk-adjusted expected returns for the average investor.
However, the market premium is just one risk factor. Empirical studies from the last few decades have led us to discover the presence of multiple independent risk factors unconnected with the risk of the market. By uncovering these additional compensated risk factors, we can take advantage of them to generate both higher expected returns and greater portfolio diversification.
The 5 Factor Asset Pricing Model
This five factor model is an asset pricing model that was presented in a 2015 paper by Fama & French. Building on their previous work of a 3 factor model, Fama & French highlight a total of 5 independent risk factors that can be used to increase portfolio expected returns while reducing risk.
These five factors are known as the Market, Value, Size, Investment, and Profitability factors. Their findings are summarized as follows:
- Market Factor – The market tends to perform better than risk-free assets.
- Value Factor – Value stocks (i.e. stocks trading below below their book value) tend to perform better than growth stocks (stocks trading above their book value).
- Size Factor – Small cap stocks tend to perform better than large cap stocks.
- Investment Factor – Firms with conservative asset growth tend to perform better than firms with aggressive asset growth.
- Profitability Factor – Firms with higher operating profitability tend to perform better than firms with lower operating profitability.
By tilting a portfolio based on all five of these factors instead of simply by market capitalization, their statistically significant findings show that we can achieve superior risk-adjusted returns. Here is a summary of the expected premiums of each of the five factors based on data going back over 50 years.
Of course, the caveat is that past performance does not guarantee future returns. However, research has shown that these factor premiums have been observed across different time periods, market conditions, and geographical markets, demonstrating the robustness of the five factor model.
A very interesting implication of the five factor model is that it actually explains away 95% of the unexplained differences between diversified portfolios, as opposed to the 67% that the single market risk factor model (also known as the Capital Asset Pricing Model, or CAPM) explained.
Intriguingly, perhaps even more important than the increase in expected returns is the diversification benefit received from the inclusion of factor tilts.
Each of the five factors have been historically uncorrelated to each other. That is, when the market suffers, others premiums like the value and profitability premiums step in to offset the negative market premium, resulting in greater overall stability of portfolio returns.
In fact, there have been virtually zero periods in recorded history where more than 3 factors were simultaneously negative:
The uncorrelated nature of these factor premiums does wonders in reducing portfolio volatility. In fact, these factors are even more uncorrelated than stocks across different geographies and sometimes even between stocks and bonds!
As we can see, the evidence points to factor investing as being one way an investor can potentially beat market returns while also increasing diversification benefits.
There is often a negative connotation associated with the word “leverage”.
We’re often taught that going into debt is bad and that we should avoid it at all costs, let alone going into debt to invest in the market.
However, leverage can have a place in a young investor’s portfolio.
To be clear, there may be several reasons why it may be good for an investor to steer clear of leveraged investing. Such examples are if you are close to retirement, have a low risk tolerance and cannot withstand large drawdowns. When used without caution, leveraged investing can spell disaster.
But why can leverage be a powerful investment strategy, when applied responsibly and with proper due diligence?
This is because leverage is a tool that can used to tap into yet another independent risk factor: time.
Diversifying Across Time
How can leverage be used to diversify across time?
Imagine a brand new investor who’s just paid off his or her debt and as a result has little in savings, but wants to start investing.
A newer investor with less funds to invest can only invest so much money into the market. This is precisely the main constraint of an investor who is just starting out.
Furthermore, since index investors are regularly contributing to their portfolio, they are inevitably exposed to sequence of returns risk.
What do I mean by that? Well, a typical investor’s portfolio contributions may be as follows:
- Invest an initial lump sum amount (for example, however much money one has at the time of opening a brokerage account)
- Periodically contribute a set amount into their portfolio, which may increase over time (for example, through regular paycheques and raises)
The result of these contributions is that your portfolio’s overall return matters much more later on, when you have more contributions invested.
For example, let’s say the market experiences a 30% increase in the first year you invest, but you only have contributed a total of $1,000. Then in the first year you only gained $300.
Conversely, if you’re one year away from retirement and have $100,000 in contributions, then a 30% increase will result in $30,000 gained from those contributions. The result is that you could have made a whole lot more in gains if you had more access to cash to invest in the beginning.
This sequences of returns risk is further amplified by the fact that we generally make more income as we age, so we have more to contribute later down the line, at a time where perhaps we should be lowering our risk as we reach the portfolio withdrawal stage of our investing.
How can applying leverage address this issue?
Leverage can be used to allow an investor to have a much more balanced amount of equities invested across their total investing horizon. For example, one can use leverage to buy more equities in their younger years, and deleverage over time as they are able to contribute more of their individual money. This is the concept behind the book Lifecycle Investing by Ian Ayres and Barry Nalebuff.
With that said, since this strategy depends on an investor’s time horizon, it works best when an investor has a longer time horizon, such as with those who are younger and don’t plan to withdraw from their portfolio until retirement.
Leveraged ETFs vs. Investing with Margin
There are two ways to use leverage in your portfolio.
One is by investing in leveraged ETFs, and the other is investing with margin.
When you invest in leveraged ETFs, the equity-to-debt ratio is reset after each trading day. This means that leveraged ETFs typically incur a higher management fee than regular ETFs, but you can also never lose more than you put into the ETF.
The same cannot be said when using margin – if the market drops substantially, you may receive a margin call and end up losing more than your entire initial investment.
The type of leverage you use depends on what type of leveraged strategy you want to use.
Turning Theory Into Practice
These strategies may sound enticing in theory, but how can we apply them into practice in our actual trading portfolio?
One of the biggest drawbacks for both factor investing and leveraged investing is arguably the difficulty in implementing these strategies into a real portfolio.
There isn’t a one-ETF solution to replicate the strategy, as is the case with traditional index investing with an all-in-one ETF. However, there are still ways that we can tap into these strategies by buying combinations of ETFs that exist in the market today.
A Practical Factor-Tilted Portfolio
There are a lot of “smart beta” ETFs that tout themselves as employing factor investing, but are actually just buzzwords and marketing jargon.
Although the industry still lacks ETFs that specifically target the Investment and Profitability factors, today there exist several solid ETFs that allow the DIY investor to create a factor-tilted portfolio with reasonable effectiveness.
The factor investing portfolio that I would recommend to Canadians is the one created by portfolio manager Ben Felix. The allocation that he recommends is as follows:
Ben Felix Five-Factor ETF Model Portfolio
|iShares Core S&P/TSX Capped Composite ETF
|Vanguard US Total Market ETF
|Avantis U.S. Small Cap Value ETF
|iShares Core MSCI EAFE IMI Index ETF
|Avantis International Small Cap Value ETF
|iShares Core MSCI Emerging Markets IMI Index ETF
|Weighted Average Expense Ratio
Notice that AVUV and AVDV contain Value and Size tilts, with some exposure to the Profitability factor as well.
A Practical Leveraged Index ETF Portfolio
I will focus here on leveraged ETFs, as they are the simpler of the two leverage options since they are just ETFs you can buy and do not require margin.
Aside from implementing a Lifecycle Investing strategy, if you’re interested in employing leverage in a portfolio, one popular way is known as HedgeFundie’s Excellent Adventure (HFEA), which is a portfolio allocation of 55% UPRO (3x S&P 500 returns) and 45% TMF (3x treasury bonds), with quarterly rebalancing.
Since this strategy is 3x leveraged ETFs, it will lead to volatile returns and with the assumption that we will maintain in a low inflation and interest rate environment.
Note that this is a more risky and less diversified type of leveraged investing that will at times experience extreme drawdowns, like the current 2022 landscape where the strategy has underperformed. I would recommend that no more than 10% of your investment account is dedicated towards this strategy.
Online Brokerages to Get Started
Ready to apply what you’ve learned and get started with factor investing or leveraged investing today?
You’ll need an online brokerage to buy ETFs and create your very own market-beating portfolio.
For any strategies that involve buying ETFs, Questrade is a great option that I personally use for my own ETF investing. That’s because buying ETFs on Questrade is commission-free, allowing for easy regular contributions to the portfolio without incurring excessive trading fees.
Furthermore, you can hold both USD and CAD, allowing you to buy US-listed ETFs such as AVUV, AVDV, UPRO, and TMF after cheaply converting CAD to USD using Norbert’s Gambit.
I have just scratched the surface on how an investor can beat market returns.
While beating the market is a compelling prospect, this should serve as an introductory glance into the topic, and I highly suggest you to do further readings on factor investing and leveraged investing if you want to dive deeper into the math and evidence.
With proper due diligence, research, and correct implementation, perhaps you’ll be well on your way to beating market returns.