Larry Swedroe (L.S.): I have spent most of my career either managing financial risks for some of the largest financial companies in the U.S. or advising other large companies on the management of financial risks. Before joining the Buckingham Family of Financial Services, I was Vice Chairman of Prudential Home Mortgage where I was responsible for managing credit, interest rate and liquidity risk. Prior to that, I was SVP and Regional Treasurer at Citicorp where I was responsible for treasury, foreign exchange and investment banking activities, including risk management strategies.

In my role as Director of Research at Buckingham and as a member of the Investment
Policy Committee, I regularly review the findings published in dozens of peer-reviewed financial journals, evaluate the outcomes, and use the result to inform formal investment strategy
recommendations for The BAM ALLIANCE.

I was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” I’ve since authored seven more books. I co-authored “The Incredible Shrinking Alpha: And What You Can Do to Escape Its Clutches” (2015) and "Your Complete Guide to Factor-Based Investing” (2016) with my friend Andrew Berkin, the Director of Research at Bridgeway Capital Management.

L.S.: If a poll was taken asking investors to name the greatest investor of all time, it’s safe to say the vast majority would likely respond, “Warren Buffett.” Thus, we could say that a major goal of investors the world over is to find Buffett’s “secret sauce.” If we could identify it, we could invest like him – assuming we also had his ability to ignore the noise of the market and avoid the panicked selling that causes so many investors to incur the higher risk of stocks while ending up with lower, bond-like returns.

“Your Complete Guide To Factor-Based Investing” is in part about the academic community’s search for that secret sauce – specifically the characteristics of stocks and other securities that both explain performance and provide premiums (above market returns). Such characteristics can also be called factors, which are simply properties or a set of properties common across a broad set of securities. Thus, a factor is a quantitative way of expressing a qualitative theme. For example, value factor can be measured by a number of different metrics, such as price-to-book, price-to-cash flow, price-to-earnings and price-to-sales. But this book is also about how practitioners use that academic research to build portfolios, and how you as an investor can benefit from that knowledge.

Therefore, it’s helpful to think about a factor as a unique, independent source of risk and return. At its most basic level, factor-based investing is simply about defining and then systematically following a set of rules that produce diversified portfolios whose components each have an expected premium return and whose returns have low correlation with the returns of the other components, providing diversification benefits.

L.S.: Professor John Cochrane famously said that financial academics and practitioners have created a factor “zoo.” He didn’t mean it as a compliment. Other researchers have forcibly reminded us recently of the dangers of “data mining.” While in some fields, this may indeed be praised, in finance, it’s generally seen pejoratively. In finance, it means that smart people with even smarter computers can find factors (adding to the “zoo”) that have worked in the past but are not “real.” In other words, they are the product of randomness (together with selection bias) and, thus, their past success won’t repeat in the future.

Andrew and I were inspired to write the book to help investors determine which of the more than 600 “exhibits” in the factor zoo investors should consider allocating their capital to. To help investors sort the “wheat from the chaff” for a factor to be considered, we recommend that it meet all of the following tests. To start, it must provide explanatory power to portfolio returns and have delivered a premium (higher returns). Additionally, the factor must be:

• Persistent – It holds across long periods of time and different economic regimes.
• Pervasive – It holds across countries, regions, sectors and even asset classes.
• Robust – It holds for various definitions (for example, there is a value premium whether it is measured by price-to-book, earnings, cash flow or sales).
• Investable – It holds up not just on paper, but also after considering actual implementation issues, such as trading costs.
• Intuitive – There are logical risk-based or behavioral-based explanations for its premium and why it should continue to exist.

The good news is that while there over 600 factors in the factor zoo, we identified just eight factors that meet our strict criteria: market beta, size, value, momentum, profitability, quality, carry and term. We then provide the academic evidence on each factor’s persistence, pervasiveness, robustness, investability and intuitiveness so that each investor can make their own informed judgment.

L.S.: The main benefit is derived from the fact that both financial theory and evidence show that these factors, or common characteristics, explain security returns as well as provide premiums. The research also shows that using a factor-based approach to building portfolios that are diversified across unique, independent factors with low correlation to each other has been more effective at reducing portfolio volatility and directionality than has the more traditional asset class diversification. The result is more efficient portfolios. Such portfolios provide investors with greater odds of achieving their financial goals and reducing the risk of outliving their assets.

Another benefit – a psychological but very real one – is that the logic and evidence we present will enable investors to stay more disciplined, adhering to their plans because they have a greater understanding of why the factors are likely to persist and also that a systemic strategy is more likely to enable them to achieve their goals than one based on some guru’s subjective opinions.

MutualFunds: What drives factor returns and how can investors achieve their risk-and-return objective through this investment strategy?

L.S.: Factor returns can be driven by either risk-based explanations, behavioral-based explanations (investors make pricing mistakes because of their all-too-human biases) or a combination of the two. For example, while almost all financial economists agree that while the market beta premium (the return on stocks minus the return on riskless one-month Treasury bills) and the size premium (the return on small stocks minus the return on large stocks) are risk-based, and that the momentum premium (the return on stocks with positive momentum minus the return of stocks with negative momentum) is behavioral-based, there is a great debate about the source of the value premium (the return of value stocks minus the return of growth stocks). There’s strong evidence of both a risk-based and a behavioral-based source. Thus, it seems likely that the premium is a result of a combination of the two sources of return premium. For each of the factors we recommend, we provide the logic and the evidence on the source of the premium as well as why we believe it’s likely to persist in the future.

We show investors how they can access factor premiums and build an efficient portfolio of factors. For example, we show why it’s more efficient to own a fund (mutual or ETF) that combines several factors (such as size, value and momentum) in one strategy than to own three funds that each independently accesses the factors.

MutualFunds: Where is factor investing headed in the future?

L.S.: Today, the factors that we recommend explain almost all of the variation of returns between diversified portfolios, more than 95 percent. Thus, there doesn’t seem to be all that much room to add incremental benefits. However, given the great incentives to find additional factors, or superior metrics that can be used to define the ones we recommend, and the great amount of human talent and computer power available, it’s foolish to believe there won’t be future additions to our knowledge of how to build efficient portfolios.