Rewarded Factors and Outperforming the Market | AWM Insights #146
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Episode Summary
Rewarded factors have been integral for investors that seek to outperform the market.
Instead of guessing and making stock picks, the use of these factors has beaten indices and stock pickers while keeping costs low and staying more tax efficient than active managers.
Incorporating more small, valuable, and profitable companies into your stock portfolio over long periods of time takes advantage of efficient risk that pays off and can supercharge multigenerational returns.
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Episode Highlights:
0:00 Intro
1:35 Our general thoughts on Equity management
2:20 How do we try to outperform active managers and indexes?
3:27 Characteristics of companies that outperform in the market.
5:08 How being a long-term investor helps you capture these rewarded factors.
7:15 These rewarded factors are proven across different time periods, regimes, and markets.
8:32 What does 2% of outperformance means in terms of the magnitude of wealth
9:31 How early planning can make huge impacts on your multi-generational wealth
11:09 How we add rewarded factors to your portfolio
12:45 Text us
+ Read the Transcript
Brandon Averill (00:15): All right, Justin, we took this show on the road. If anybody's watching, you'll notice the background's a little bit different. I know our kids watch, so maybe they'll notice.
Justin Dyer (00:24): Oh no, there you go.
Brandon Averill (00:25): So they are the couple subscribers we have on YouTube. But in all seriousness, we're on the road and we're in Arizona, but we didn't want to miss a week, so we're back at it. We've been teasing out, obviously for clients, a little bit of our thoughts on how we actually structure the portfolio, go through that, the construction, the financial architecture of their situation, and gotten to the point now when we're talking about the stock side of their portfolio and how we go about it. And I know last week you talked a little bit about, made a comment around the passive of investing, index investing is good for most people and obviously that's intriguing a little bit because people listening to this, our clients are not most people.
(01:14): So I thought it would be good for us to walk through a little bit today, what do we do in the implementation side of the portfolio? What are some of the key points of our investment philosophy? Why do we think it's different? Why is it data driven? All that type of stuff. So love to just maybe kick off there, Justin, if you don't just mind diving in? I think the simple question is, is a lot of times people associate passive investing or index investing with passive investing, but we're not sitting here just trying to get the return of the market, right? We're still trying to outperform.
Justin Dyer (01:51): Yeah, exactly. We are trying to outperform and how we go about doing that is driven by the data. We've said it time and time again, you mentioned it, and hopefully it's becoming clear as to why we take that approach and this hopefully takes it a little bit of a step further. And going back even to last episode and what you've already reviewed, we do think starting with the index based approach makes a ton of sense and that's actually a phenomenal return. If you look at the history of what indexes have provided. Typically an index by itself outperforms active managers for a couple different reasons.
(02:30): Active managers typically have substantially higher fees and they also trade a lot more so they're less tax efficient. And I say those two things because those are two components that we add back, if you will, to an index based approach to help us outperform. You don't necessarily see those on the bottom line, but I just want to hit on expenses matter, taxes matter and having an awareness around that within your portfolio is one simple, really simple way and often overlooked. It's a kind of amazing way to outperform.
(03:00): But then getting into the data of what the indexes actually tell us and how we can use that to outperform, is where I'll go next. So if you take an index and you look at different characteristics of the companies that make up an index, you can say, "Hey, let's look at the smaller market cap companies or just simply the smaller companies versus the larger companies and look at the performance of those two categories over time. Guess what? The smaller companies tend to outperform. Not every single year, but over long periods of time. I have right here, from 1928 to 2021, so a year old or so, but the data's still totally relevant. Small companies have outperformed by almost two percentage points. I mean that's substantial. Absolutely substantial.
(03:52): Then you can look at things like, what's called, relative price, so that these are high cost companies, highly valued companies versus low valued companies. You can think about these as valuation type metrics. The lower value companies outperform the growth oriented or the higher value companies. And then another factor or category, as the term I'm using here, is profitability. Companies that have a higher level of profitability outperform those that have a lower level of profitability. Again, this doesn't happen each and every year, but these are two or three, excuse me, categories are what they're called in the academic or investing world, factors, that have shown you can outperform the index by tilting a portfolio to these various factors in different amounts to again outperform.
Brandon Averill (04:44): Right. And I think the important part of this is the reason why, and you hit on it a couple times, is this doesn't show up all the time. And so you have to be a long-term investor. And going back to what we've been talking about over the weeks, is you have to have the proper financial structure in place, because what we're talking about here is all of your essential priorities must be met before we start to allocate to the equity markets.
(05:10): And what that allows us to do is take an approach where we're willing to go some of those years where these factors don't show up, these dimensions don't show up because we know that when you get out seven, 10 years, you're building the growth of your portfolio. And what you're doing here is you're using that wealth of academic research to position yourself for higher expected returns over a long period of time. If we felt like that we had to just give that immediate return back, then you're going to probably not go down this route. You're not going to expose yourself to the potential swings of a portfolio if you don't have a long-term timeframe.
Justin Dyer (05:51): Totally. And I mean quite honestly, you shouldn't be in equity if you don't have a long-term timeframe. But no, your point is 100% correct. We have confidence in this outperformance or this likelihood of outperformance because we are allocating money over the long term. 100%. That is an incredibly important component. A couple other things I'd say too is, the nice thing about these three factors is they don't move in lockstep by themselves. They don't move in the same way. There's diversification you get within these factors as well. So value as an example, hasn't performed super well over the last 10 years to be honest. So going directly to your point, it can be a long period of time, but these other factors have actually done okay at various times over that same period of time.
(06:35): So the other thing I want to hit on, and I'm going to not go too far down the rabbit hole here, but I could rattle off these three factors and say, "Okay, well, they've outperformed by two, to three, three and a half percentage points over long periods of time." That's great. That's US markets. The good thing is you actually see this across the world. So you see this in international developed market, you see the same characteristics in emerging markets and that's where you start to get more and more confidence. Just because we're looking backwards, actually shouldn't tell us too much on its own. This goes back to us being very data driven and rigorously data driven.
(07:13): So if I'm just looking back at the data, I could find any store I want and our listener should be very, very, very skeptical of someone just looking backwards. It's adding that additional layer. "Hey, is this pervasive across different marketplaces? Do you see this over different periods of time?" Et cetera, et cetera. Is there a logical model that supports us as well? And the answer to that is, yes. Not to go too far down this too, it's risk and return are related. Smaller companies typically are a little bit riskier than large companies, but if you can diversify, you get to diversify that risk away and still benefit from the expected return.
Brandon Averill (07:52): And I think to clarify for clients listening, when we talk about risk too, we're referring to something called volatility. So just meaning that the swing is in the portfolio, it's not the risk of necessarily going out of business or losing all of your money. So it's a different definition of risk there. And that risk over long periods of time, meaning volatility, kind of smooths out. And so, you reference 2% of a premium, so increased performance of roughly 2%. I think some people listening to this might go, "Well, 2%, okay, great." 2% over a long period of time means a lot. And-
Justin Dyer (08:29): So play around with those numbers if you're curious.
Brandon Averill (08:30): Put some numbers to it. I mean this is a long period of time and nobody's in, well our clients, you guys are investing for this period of time because we're dealing with multi-generational wealth. So we are dealing in hundreds of years, but from 1926 to 2021, people reference the S&P 500 a lot, if you would've invested $1 in the S&P 500, your dollar after that time period will be worth roughly $14,000. Pretty phenomenal. Participating at that level, I don't think anybody's sad about that. But what we're talking about is just taking a slight turn. And so instead of that 14,000, if you would've taken that $1 and put it in the smallest US companies, you would've ended up with just over $37,000. It's a substantial wealth effect when you're talking about multi-generational approach. And I think clients know this from meeting with us over time, but we're always, we talk about backdoor Roth IRAs and $6,000 a year and getting money into the right accounts and they all seem like small amounts, but I mean the magnitude of them over long periods of time is just huge.
Justin Dyer (09:38): Oh yeah, well you hit on the raw return data and then you add on these little tiny things on top of it, that to your point, 100% correct, add up to be something substantial than by themselves. And that kind of goes more to the tax and expense bucket. You're actually outperforming even more than you are as those numbers state and highlight. So I think that's an important point too. The behavioral side or the tax bucket, how we plan and control for taxes and minimize taxes adds substantial value as well.
Brandon Averill (10:12): And I think the last thing maybe to come to a close here is, what we're also not doing for those of you listening, is taking your money and saying, "Forget the S&P 500. We're going full force towards the small companies." And the reason being is because there are going to be some years where it doesn't show up and your life just doesn't work that way. And so we're building a portfolio where we want to, in a prudent way, tilt enough money into those areas that it does give us the highest expected returns over time.
(10:46): And you used the ice tray analogy last week, and I'll use college football this week, is if we're looking at trying to bet on the team that's going to win the national championship, we sure as heck wants some money in Georgia, we want some money in Alabama as much as it pains me, you go down the list, right? There's probably 10 teams that you want money in, but TCU made it this year. Next year, you probably want a little bit of money in them, but do you want as much as Georgia? Probably not. So instead of going full Georgia boat next year and things can happen, we're going to just tilt, we're going to put a little bit more money in Georgia, probably a little bit more money in Alabama, but we're still going to have some money in TCU. So that's how we're ultimately looking at your portfolio.
Justin Dyer (11:31): And I want to make sure we underscore this is public market investing.
Brandon Averill (11:34): Correct.
Justin Dyer (11:35): The private side is really just almost as opposite as you could imagine. And we'll probably get into that in the next episode.
Brandon Averill (11:44): Way to tease it out. Yeah, I think next week we should certainly go into the private side. We've built out how we allocate your guys' money to the public markets, the public stock market. And the big question comes for those of you that have gone through this exercise and kind of gotten to the sufficient resources to meet your priorities, you've had this conversation for others, it'll be new. But really, how do we think about it? Once we've accumulated enough money, we've allocated appropriately in our financial structure and we have excess, what's the next level of higher expected returns? And that does come in the version of the private markets and we're obviously passionate about that. We're very active in that. And so we'll unpack that in a future episode here. But we'll wrap up for today.
(12:30): Reminder, we got this phone number, 602-704-5574. Shoot me a text, Justin and I'll discuss it and we'll banter about in a future episode on anything you have. And until next time, own your wealth, make an impact, and always be a pro.
(12:51): All right.
Justin Dyer (12:51): Cool.