Perhaps second to the absolute question of how to make money in the markets, I am next most often asked if and how it is possible to “beat the market”. When asking “how to beat the market”, one also needs to answer two parts of that question: “what do you mean by ‘the market’?”, and what qualifies as “beating it”?
What is “the market”
Some US investors think of “the market” simply as the S&P 500 stock market index, and for about 40 years, that one world-class index has been the epicenter of a fee war between index fund providers to invest your money in line with this index for fees now as low as a few basis points (that is, fees totaling a few dollars per year per $10,000 invested). More globally minded investors might look beyond the S&P 500 to a more internationally diversified index like the MSCI World or FTSE All-World Index, as broken down below. Of course, investments include far more than just stocks, and should also consider bonds, real estate/property, and alternatives, but for this article, we will consider only the factors that have driven some stocks to outperform the broader stock market averages over time.
What does it mean to “beat the market”?
The obvious answer to what it means to “beat the market” is to simply make more money, in absolute terms, than the same amount of money invested in a passive index fund. I would argue that earning about the same return as the market, but doing so with fewer risks and fluctuations, would also count as “beating the market”.
Which factors have outperformed the market recently?
If you have been reading my investment writings for a while, you will know I am a long-time fan of the value, size, and quality factors. These factors, respectively, mean buying companies trading at relatively low prices to their cash earnings, buying smaller rather than larger companies, and buying companies with relatively high profitability and low debt ratios. I have also been a fan of buying stocks with relatively low volatility and low beta measures (meaning stocks that don’t move up and down as much as others in the market), but only recently have been starting to appreciate that these stocks statistically have had similar total returns as stocks that fluctuate more. About a year and a half ago, I posted a year-by-year performance of these different factors within the S&P 500, showing how these factors performed relative to one another in the first 16 years of this century.
Below are some statistics of how these factors have performed over the past three and a half years, during which time Blackrock iShares Edge factor ETFs (links in the table) tracking each of these factors have been available to compare against the MSCI World Index (the “Core” ETF). Some factors worth noting:
- Momentum had the highest absolute performance, but also fell the most in its worst month. The strategy rode high-flying tech companies on the way up, but only trimmed positions in them after they fell.
- Quality was the second best performer, and also has been the second least risky (by volatility and “worst month” measures), indicating the relative safety of investing in relatively high quality companies.
- The “Min Vol” factor (buying more of companies that fluctuate less than the market average) matched the absolute performance of the “core” market, but did so with less volatility and drawdown.
- The size factor has underperformed in recent years, as larger companies have risen in value faster than smaller companies, while the value factor (buying higher yielding companies, trading at lower price multiples to earnings or book value) as growth companies have continued to experience “multiple expansion”. Historically, these two factors tend to mean revert, which is why I expect small cap value is likely to outperform large growth over the next 5-10 years.
- Multi-factor funds are naturally more complex and tend to be more expensive, and the iShares Edge one below seems to have not been worth the higher fee in recent years.
| MSCI World Factor Statistics, October 2015 – March 2019 | |||||||
| Core | Min Vol | Momentum | Value | Size | Quality | Multi-Factor | |
| Average Annualized Return | 10.9 | 10.9 | 14.4 | 8.2 | 9.5 | 11.4 | 9.8 |
| Annualized Volatility | 11.3 | 8.9 | 12.0 | 12.6 | 12.3 | 10.8 | 11.6 |
| Worst Month | -7.6 | -5.6 | -9.9 | -8.4 | -8.9 | -7.0 | -8.2 |
Country allocation
In addition to quantitative factors like those compared above, country allocations also have an impact on the risk and return of an investment portfolio. In recent years, portfolios with more US stock exposure have tended to outperform those with more non-US stock exposure. When asked “is the market too high right now?” or “is now still a good time to invest after the markets have risen so much?”, I often find that too much attention has been paid to the S&P 500, and not enough to the many other foreign markets trading at less expensive levels.
Hope this has been a useful update on global factor investing (sometimes known as “smart beta”). Do contact me or leave a comment below if you have questions or want to exchange ideas.