Institutional Investors

Why Factors Premiums Should Persist

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Factors Premiums

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This article originally appeared on ETF.COM here.

There are two big, ongoing debates relative to index (or, more broadly, passive) investing. The first is whether active or passive (which I define as neither market timing nor individual security selection) management is the winner’s game (the one most likely to allow you to achieve your goals). The overwhelming evidence, as presented in my book, “The Incredible Shrinking Alpha,” shows that passive investing is the prudent choice.

The other debate that rages on is if a total-market approach (with John Bogle often seen as the standard-bearer) is “best,” or whether “titling” a portfolio to well-documented factors is likely to produce higher returns, and perhaps higher risk-adjusted returns.

During discussion about this second issue, perhaps the most-asked question I hear goes something like this: We know the historical evidence shows premiums for these factors, but how can you be confident that factor premiums will persist after research about them is published and everyone knows about them? After all, we are all familiar with the phrase “past performance does not guarantee future results.” I thought it worth sharing my answer.

Argument for persistence

The first thing I point out is that we live in a world of uncertainty. There is simply no way to know for certain whether a factor premium will persist in the future; that goes for all factors, including market beta.

A good example demonstrating this point is that, using data from Dimensional Fund Advisors, from 1969 through 2008, the Fama-French U.S. large-cap growth index ex-utilities returned 7.8% and underperformed long-term (20-year) Treasury bonds, which returned 9.0%. That’s a 40-year period in which investors took all the risks of stocks in this asset class (which today constitutes about 50% of the U.S. market’s total capitalization, down from about 70% at the end of 1999) but still underperformed long-term U.S. Treasuries.

Given that any strategy of investing in risky assets can fail to deliver a risk premium, no matter how long the horizon, we must make decisions in the face of uncertainty, recognizing that the best we can do is to put the odds in our favor. That raises another question: How can we best put the odds in our favor?

Read the full article here by Larry Swedroe, Advisor Perspectives

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