Ep. 135 Beyond Indexing:  An Optometrist’s Guide to Factor-Based Investing

[00:00:04] Evon: Hey everybody. Welcome back to the Optometry Money Podcast, where we’re helping ODs all over the country make better and better decisions around their money, their careers, and their practices. I am your host, Evon Mendrin, Certified financial planning practitioner and owner of Optometry Wealth Advisors, an independent financial planning firm just for optometrist nationwide.

[00:00:25] And thank you so much for listening. Really appreciate your time and attention. And on today’s episode, I’m going to continue the sort of investment series that I’m on, and we’ll dive into an optometrist guide to Factor-based investing. In the last episode, episode 134. I dove into why Optometry should embrace passive investing and index investing index funds, and I dove into the history and the research and academic roots behind it and why we would expect index investing to work now and into the future, and just why it is so unlikely that active investment managers, either you or I, or professional managers managing mutual funds to outperform their broad market indexes. And if you haven’t listened to that one, highly recommend you go back and listen to that one first before jumping into this one. Why does this matter? Well, as optometrists often practice owners managing both practice and personal finances, you’re taking the cash flow that you get from your work and your practice.

[00:01:32] And to first reinvest back into your practice and then into investing in other assets. It could be in your retirement accounts at work, it could be into other accounts, it could be into real estate. Whatever it is, you’re taking that cash flow and continuing this habit over and over again of investing it into assets, and as you do that, you need an investment approach that number one, you understand.

[00:01:54] That is expected to work over the long term, meaning there’s evidence to suggest that it would work over the long term and that you can stick with. And the question that comes out of that discussion around index investing and broad market investing like that is that, well, can we improve portfolios above and beyond broad market index funds?

[00:02:17] Can we improve our investments beyond just picking the global stock market index fund that’s available to us? Without falling into the trap of trying to be this really active investor betting on individual stocks or trying to time the ups and downs and the evidence points to yes, in fact, the same academic work – in fact, a lot of the same people – that led to index funds, and that explains why Index funds work continues on. And it builds on top of itself, which leads us down to the road of factor based investing.

[00:02:53] What is a Factor? And What Is Factor Investing?

[00:02:53] Evon: So what is a factor? A factor is just a common characteristic across a bunch of investments.

[00:03:02] As academic researchers have work to understand what really drives markets. And if we’re, we’re buying a stock, we’re buying the future cash flows of these businesses, and they’re trying to understand or create models to explain how much we should be willing to pay for those cash flows. Given the risk and expected return of that company, not much different than if you’re buying an Optometry practice.

[00:03:27] And then finally, what explains the differences in returns between different broadly diversified portfolios, meaning your portfolio and your peers portfolio, meaning your, just all of your investments combined and my, my bundle of investments, they’re all gonna behave differently. So what explains the differences in their behavior and their returns. And academic work has brought out these certain factors or characteristics are common across a bunch of investments that help to explain variations in returns. And this isn’t only in investing. So what I, something I’ve learned from a peer of mine, a fellow advisor, is that they have factor models or groups of characteristics, groups of factors for personalities.

[00:04:12] There’s even a five factor model that talks about these five characteristics that primarily explain the differences in personalities between different people. They’re not the only characteristics, but the characteristics that have the strongest ability to explain differences in personalities between you or I, or, or a group of us.

[00:04:32] And so we find a similar thing here in investing where research has found that certain factors or characteristics have been shown to explain the risk and return of investments, and importantly have been shown to have a higher return over long periods of time versus their counterpart, meaning those factors, those characteristics have given a premium, an extra return.

[00:04:59] For investing in that group of characteristics rather than their counterparts.

[00:05:04] So what is factor investing? Well, factor investing is targeting or tilting toward specific evidence-based stock characteristics – we’re we’re gonna be basically just talking about the stock market today – stock characteristics or factors that are tied to higher long-term expected returns.

[00:05:21] What Makes an Investment Factor Reliable?

[00:05:21] Evon: And what makes a reliable factor? there are, if you look at enough papers, there are hundreds of factors proposed out there, all trying to explain some factor characteristic that provi leads to a higher expected return. sometimes you’ll see this referred to as the factor zoo, like everywhere you look, there’s a new factor popping up here or there to, to look at.

[00:05:45] a lot of those though are short term anomalies that are based on just pure randomness. They’re, they’re not significant or are, or are so small that if you actually try to invest in them, just the cost of trading in managing it would eat away any of the extra returns. So they’re not really reliable characteristics.

[00:06:06] there are, there is a small, really small group of commonly held factors. That have been shown to be robust and reliable, and there are some criteria to figure out what is a, what makes a factor reliable.

[00:06:20] So in addition to actually showing up in the data and providing an excess return, we see five common criteria for robust, reliable factors. And Andrew Berkin, who I’ve had on the podcast and his co-author, Larry Swedrow, who do a great job of describing this in their book, Your Complete Guide to Factor-Based Investing.

[00:06:43] There are five criteria, and those are, number one, it has to be persistent, meaning this characteristic has to work across time and different economic regimes. We can’t be cherry picking a particular five or 10 year period across a hundred to 200 years of of history. It has to be persistent across periods of time.

[00:07:02] Number two, it has to be pervasive, meaning it has to work across global markets and sectors, even different categories of investments. So it has to work across geography. It can’t just work in one particular market and not work anywhere else.

[00:07:17] Number three, it has to be robust, meaning it has to hold up to different definitions and measurement of that characteristic. We shouldn’t have to torture and tease out a very, a very specific way to describe it in order for it to work.

[00:07:31] Number four, it has to be investible. Meaning that even if it shows up on paper, it ha you have to be able to actually implement it in real life.

[00:07:41] Cost effectively, and it still has to work after costs.

[00:07:45] And then lastly, it has to be intuitive. It has to make sense. There has to be some logical economic explanation for this. It can’t simply be, Hey, you know, all stocks that start with T tend to do better than stocks that start with S That might show up in the data, but there’s no economic rationale for why we should expect that to continue.

[00:08:08] And so persistent, pervasive, robust, investible and intuitive. You might look at, I don’t know, like that diagnostic tool in the same way, it has to work consistently. It has to work across patient populations. You have, it has to work using different measurement approaches.

[00:08:23] It has to be practical to actually use in your clinic. And have a clear scientific rationale. Maybe you have a similar framework for looking at things like that. And so if it meets these criteria, it’s likely not to be just data mining or just pure randomness, but reliably and robust something we can expect to continue into the future.

[00:08:44] What Investment Factors Should Optometrists Know About?

[00:08:44] Evon: So what are these factors that we’re talking about? What are the characteristics? Well, there is a core set of three to five or six characteristics that are not only show up clearly in the data historically, but are widely accepted as reliable, robust characteristics.

[00:09:01] The Market Factor – Investing In the Stock Market As A Whole

[00:09:01] Evon: And the first one is the market factor.

[00:09:03] And this is simply your exposure to the stock market as a whole. The, the entirety of the stock market is itself a characteristic that explains the returns of a portfolio. And the premium that it gives you is often defined as the return of the stock market minus the return of short-term treasury bills, US treasury bills, which are sort of the risk-free return, right?

[00:09:27] There’s, there’s essentially no risk for those short-term treasuries. And so the differences there is the premium, the extra returns that you either got historically or would accept for taking on the risk of investing in stocks. It’s often called the equity risk premium. This is what you’re demanding as an investor for taking on risk.

[00:09:47] And this goes back to, 1960s, Bill Sharp’s Capital Asset Pricing Model, which you may have heard of if you’ve taken any Intro to finance classes. Or MBA courses, even though the model itself doesn’t work in real life, it, it’s still often taught in MBA courses. And this is also where that jargon word, if you ever heard the jargon word beta, this is where beta comes from.

[00:10:09] It’s a measure of something’s volatility relative to the stock market as a whole. or if someone says, Hey, you’re, you’re just getting beta, that just means you’re getting exposure to the market as a whole. And this is really important research, sort of putting, putting on paper, this relationship between risk and return.

[00:10:30] Before this, you know, you can imagine any stockbroker at the time, anytime there was positive performance in client accounts, they’re taking credit for it. It’s, this is, hey, this is their, their unique skill, right? This is their skill that’s providing that return. And then research like this comes along and says, well, no, not necessarily.

[00:10:48] In fact, all you’re seeing there is investors getting compensated for investing in stocks as a whole. This may have nothing to do at all with the skill of the manager, but this is simply the return that clients are getting, that investors are getting for investing broadly in the market as a whole.

[00:11:06] And if stocks or some manager is expected to have higher returns in the market, then they’re only doing that by taking on more risk. Not necessarily because of their skill. And so the amount of stocks you own, really your exposure to the stock market is able to explain, statistically about two thirds or about 66% of the differences in returns between two mixes of investments, my mix of investments versus your mix of investments.

[00:11:34] This has a lot of explanatory power. Which sort of highlights how important of a decision it is based on your time horizon based on your investment goals and just your ability to accept investment risk, how important of a decision it is, how much stocks you’re gonna have relative to other things like bonds, and how that changes over your lifetime as you get closer and closer to needing to use the funds because this will explain the majority of your returns and risk over your, over your lifetime. and this is where most people’s knowledge tends to end. I mean, most of you probably intuity have an understanding that yeah, the stock market is riskier than government bonds. We’re, we’re expecting because of that, to be compensated with higher returns.

[00:12:17] they’re not guaranteed. They’re definitely not guaranteed. In fact, we’ve seen long years, you know, if we look back at rolling periods historically. looking back, for example, in the US from 1926 through 2024, over one year periods, this premium showed up, meaning US stocks had a higher return than US treasuries only 70% of the time.

[00:12:41] Now that’s the majority of years, but there are still plenty of years where stocks in the US did not outperform US treasuries. And if you look over five year periods of time, that extended to, 79%, 10 year periods of time, it’s 86%, 15 year periods, 96%. And then the longer you extend that time horizon, the more reliably stocks have outperformed government bonds.

[00:13:05] But there are long periods of time where you see that that premium, that excess return doesn’t show up and it can be uncomfortably long periods of time. So, for example, in the US we look back the last 15 years at how well US companies did relative to the rest of the world and especially the largest US companies, the largest tech growth US companies.

[00:13:29] and we kind of expect that to continue on for the rest of our lifetimes, but that’s not necessarily the case. What we do there is we forget about the decade before because the early two thousands, there was an entire 10 year period where US stocks did not outperform government bonds, in fact provided a slightly negative return for a full 10 year period for a full decade.

[00:13:51] That’s a long time, and you have to be willing to accept that risk to go through that in order to get that potential, that expected higher return. It’s not guaranteed. There are periods of time where you’re not gonna see that. Berkin and Swedrow in that book I’d mentioned earlier, put it perfectly well, they say “the important takeaways that if you want to earn the expected but not guaranteed premium from a factor, you must be willing to accept the risks that there will almost certainly be long periods when the premium will turn out to be negative. When the premium, when when these characteristics do not do better than their counterparts, it’s going to be cyclical.

[00:14:33] You should expect that to happen. The, the stock market as a whole is no different. We see the same thing in international, in short term periods of time, there’s more uncertainty there over long periods of time, the more you extend that time horizon, the more reliably that shows up.

[00:14:47] And if you are investing in broad market index funds, this is basically what you’re trying to get. You are just trying to get the market factor and you’re trying to get it as cheaply, as inexpensive as possible. and this is where most people’s knowledge, with the research tends to end, right?

[00:15:02] I think most people have an understanding here, but it’s not where the research ends cause as we mentioned, this didn’t explain all the differences in return. It didn’t account for all the differences in return. There were other characteristics. There were, in the research, you might hear it called anomalies that weren’t explained by this model.

[00:15:20] There’s something else going on there. There are other unique sources of risk and return that weren’t accounted for here. And so as the research went on, eventually led to other characteristics.

[00:15:29] Small Factor – Small Companies vs. Large Companies

[00:15:29] Evon: For example, the small factor. So these smallest subset of companies tended to outperform the largest subset of companies, especially over long periods of time.

[00:15:38] The Value Factor – Cheaper Companies vs. Expensive (Relative to Their Financials)

[00:15:38] Evon: The value factor is another one. So value stocks, which are cheaper stocks relative to some financial metric, like relative to earnings or cashflow or, the book equity on the balance sheet. Those value stocks, those cheaper stocks tended to outperform the more expensive growth stocks, which, you know, for example, a lot of the tech stocks tend to be growth like stocks.

[00:16:03] The way I explain this to clients is that if, let’s imagine you’re, you’re trying to buy an Optometry practice and you’re looking at two of ’em. And if you look at the financials, they have the exact same revenue collected. They have the exact same cost of gets sold, the exact same operating, expenses, the exact same net profit, the exact same, net income.

[00:16:23] And the exact same cash flow, but one of them is priced much more cheaply than the other one. Which of those would you expect to have a higher return on your dollars if you were to buy one? Well, the right answer is, is the cheaper one, because you’re able to buy the same cash flows, the same earnings at a cheaper price.

[00:16:40] But as we’ll talk about later, that price is telling you something. There’s something going on in that practice that’s leading to a cheaper price, to cheaper valuation. So the value factor is another one. And putting these three together, 1990s, Eugene Fama, Kenneth French, really influential and in fact Nobel Prize winning, researchers, put these together into a three factor model, meaning there’s a set of three characteristics here that explain over 90% of return differences between mixes of investments, between different portfolios. These are characteristics that most heavily explain what drives markets.

[00:17:22] These are some of the most, the most widely acknowledged ones, but they’re not the only ones.

[00:17:26] The Profitability Factor – Profitable Companies vs. Less Profitable

[00:17:26] Evon: The research continued, what eventually led to the profitability factor or its cousin – you might hear a, a different one called quality, but the profitability factor, meaning companies with higher profitability tend to outperform companies with lower profitability, as measured in the research.

[00:17:43] Turns out operating profits. Very important.

[00:17:45] The Investment Factor – Heavily Growing Assets vs. Companies With More Slowly Growing Balance Sheets

[00:17:45] Evon: The investment factor is another one. meaning that the meaning that businesses with high growth in their assets on the balance sheet, meaning they’re investing really heavily into new assets, new equipment, things like that. Those companies, especially in the smallest subset of companies, tended to perform worse than companies that do not have as quickly growing balance sheets. and this is most noticeable in smaller companies, interestingly. and as you add those together, Gene Fama and Ken French put together this sort of five factor model, which, which explains again, even more of the return differences or what drives markets.

[00:18:23] Momentum – A Curious Short-term Anomoly

[00:18:23] Evon: And then one last one I’ll just mention is momentum, which is fascinating because what that is is that stocks that have done well recently in the short term, tend to continue to doing well in the short term.

[00:18:35] And stocks that have done poorly in the short term. Tend to continue to do poorly in the short term. And this is fascinating because it’s a purely short-term behavioral phenomenon. This is an an anomaly that is not intuitive. There’s no real intuitive risk-based explanation for why it should exist, but it is strongly documented in the data.

[00:18:57] And so we have these key characteristics here that explain the vast majority of differences in in different portfolios. Mine to yours, yours to peers, but also what tend to drive markets. So we have the market factor, your investment in the stock market as a whole. And then within stocks, we have small companies, we have value companies, and we have profitability with the addition of honorable mentions, investment and momentum. and as we talked about in those initial, this initial criteria, yes, they show up very clearly in the data historically.

[00:19:32] they are persistent, meaning they show up across time as far back as the data will let us go. And just like we talked about with stocks in short term periods, there’s a lot more uncertainty there, but the longer your time horizon extends, the more reliable those premiums show up.

[00:19:48] and what’s interesting is that they show up at different times value. For example, the premium for value shows up at different times from profitability. When value’s doing well, profitability doesn’t tend to do as well. And when value’s doing poorly, profitability balances it out.

[00:20:03] And so you have another sort of layer of diversification. You’re able to spread out your dollars across unique sources of risk and return and sort of improve the reliability of the returns here.

[00:20:14] And they are pervasive in that they show up across markets. They show up in the United States, they show up in developed countries outside of the United States, and they show up in emerging markets. And interestingly like we look over the last 15 years as we’ve talked about.

[00:20:27] Large growth US companies have done phenomenal, which means that small value US companies have not shown up. That premium hasn’t shown up in the US in recent history. However, that’s really a US phenomenon outside of the United States it’s been a different story. Those have been showing up outside of the United States.

[00:20:48] And so we’ve see that international diversification, global diversification can enhance the use of these characteristics. Or maybe it’s the other way around.

[00:20:54] Maybe it’s these characteristics enhance global diversification

[00:20:58] and they are robust, meaning they show up under different definitions of each of those. they’re investible, meaning they can actually be invested in, in real life, in real life funds. And the premium still exists after costs. with the exception of momentum. It’s debated whether momentum can actually be invested in specifically like as a specific strategy or whether it’s something you invest in passively, for example, by simply being patient of when you decide to sell something, if it’s having positive momentum or patient if you’re deciding to buy something, if it’s showing that negative momentum.

[00:21:34] So that’s, that’s the only one that’s sort of a little bit different there, but they are investible. They work in real life and they’re intuitive. There is, as we’ll talk about, there is an explanation or rationale for why they should exist and why we should continue to see them exist.

[00:21:48] Why Do These Investment Factors Exist?

[00:21:48] Evon: let’s talk about why do these factors exist?

[00:21:51] The reality is we can’t know with certainty. We know they show up quite clearly in the data. They do exist, but the explanation can’t be certain. I mean, ultimately this is as close to we can get as making investing a science, but ultimately economics, which is finance, falls under economics.

[00:22:09] It’s a social science. There’s some art here. There’s some uncertainty. And so one of the primary explanations that I think makes the most sense is that these are compensation for taking on additional risk.

[00:22:21] With stocks we know, for example, quite intuitively that businesses that owning businesses carry higher risk than owning bonds, especially US government bonds businesses can legitimately, you can lose your full investment.

[00:22:36] You know that if you own a practice, there is risk involved with owning the business. However, if you’re a bond holder, you’re at the top of that list to get as much of your capital back in a bankruptcy as you possibly can. The time horizon with a stock is perpetual with a bond there’s a maturity date and with US bonds, with US treasuries, the United States can just simply, can literally create money to pay its obligations. And declines in stock prices, often follow periods where, there’s economic distress and your income is expected to be impacted, for example.

[00:23:07] So the stock market carries additional risk relative to bonds. And you are getting compensated for taking on that risk.

[00:23:14] Small companies, we can intuitively understand that small companies have higher risks than their largest counterparts. They’re potentially more susceptible to economic declines or distress.

[00:23:26] the cost for them to raise money to raise capital is going to be higher in terms of lending, in terms of. You as an investor, you’re gonna demand a higher return for those to investing in those small companies.

[00:23:37] Value companies. When we look at the research around what these value companies look like, we see that they are cheap because they tend to be companies in distress with high amounts of debt and have high earnings risk.

[00:23:50] they’re much riskier than growth stocks in bad economic times. They’re very sensitive to recessions, but less risky relative to growth stocks during economic expansions. So clearly risk. When we look at what these companies look like, risk is an explanation that makes sense. If you are going to invest in these companies, you are wanting to be compensated for taking on that additional risk.

[00:24:13] And then you and I as investors can decide, okay, we have different preferences. What risks are we willing to take on? How much of the stock market are we willing to invest in versus other things for our goals in our time horizon? Are we willing to take on these other risks in addition to that? So we can, we can start to think about, okay, what risks are we willing to take on and can we spread out, diversify our dollars across as many unique sources of risk and return as possible?

[00:24:42] so risk is a part of that. There’s also behavioral explanations when you think about value, for example, even profitability. this idea that investors prefer these exciting growth stocks. Tech stocks, for example, are a good example of that investors prefer to, to put dollars into these exciting flashy growth stocks, which tends to drive up their price and overreact to bad news, which tends to lower the price of value stocks. So there might be a little bit of both there as we, as we think about the explanations for that. But I think there’s a clear risk rationale for most of these factors.

[00:25:16] And if so, we should continue for that to exist.

[00:25:19] Do Factors Go Against Efficient Markets?

[00:25:19] Evon: And one, one of the questions that also comes up is, well, you know, Evon, you, you just talked in the last episode about markets being, for the most part efficient, setting fair prices based on the information at hand and, and how difficult it is to outperform the market.

[00:25:34] and that’s true. And it sounds like these factors are trying to outperform the market, which is also true. Does this fly in the face of market efficiency, right. Of, of this whole concept and not necessarily. If it’s a story of you being compensated for risk, we should expect that to continue in an efficient market.

[00:25:57] If, if markets are efficient and prices are set fairly well, you’re seeing fair prices. The prices of a, of a company, just like the value of your Optometry practice, tells you something about that business. The price tells you something about the risk and return you expect with that business and how certain or uncertain the earnings are and the cash flows are of that business.

[00:26:22] And we wouldn’t expect every business to have the same exact expected returns and expected risk. Going back to that idea of buying two practices, one practice is more cheaply than the other. However, as you’re going through your due diligence, you’re asking yourself, why is this practice so cheap?

[00:26:40] Something’s going on in that business for that owner to be willing to take on a lower price. the owner is burned out and just needs to get outta the business. The patient demographics are dwindling. the office and all the equipment are outdated and are gonna need to be replaced. So essentially you’re taking on a cold start anyways, reputational risk, like something is going on in that business.

[00:27:01] And so the future earnings of that business are more uncertain. And so because of that, you as an investor, you’re gonna demand a lower price and a higher return, right? So we, that’s something we would expect to continue. Investors are gonna continue to want to be compensated for taking on additional risk.

[00:27:21] If it’s a purely behavioral phenomenon or anomaly, well, not so much. You would expect that hedge funds professional investors are gonna get in there and sort of arbitrage those away. So many of these actually fit squarely well in efficient market, you would expect them to be there and to continue.

[00:27:38] Is Factor Investing Really Passive Investing, Or Active?

[00:27:38] Evon: another question that comes up is that, well, is this really passive investing? This sounds really active ’cause I talked about again, in my last conversation, why I believe passing investing still works. And I think it really depends how you define that. if you define passive investing in the way, it’s sort of been defined in a lot of ways where it’s sort of these two check boxes.

[00:27:58] It’s either an index approach, which is passive. Or a non index approach. And anything that isn’t an index fund is an active investment approach. So if you define it that way, well, it’s not indexing, so it is active. And they sort of have to call these, if you look at some of the companies that provide ETFs around this, for example, they have to call them active ETFs because they’re not indexed.

[00:28:20] But in real life, that’s not really how passive And as active investing work. Really passive investing is sort of muddy. And the way I define it is that you are investing in a broadly diversified way based on a clear, transparent, and systematic set of rules. And not by intuition in trying to pick the best individual stocks or investments and trying to time swings.

[00:28:45] and if you think about index fund, an index is just a list with a set of rules that decides who’s in it. , and so this sort of factor based approach is taking what works really well in indexing, which is a broad, diversified, low cost, tax efficient way of investing with a set of rules and taking it to another step.

[00:29:07] And rather than investing in a very rigid index, they have more discretion and flexibility and are changing the rules to weight towards these other characteristics. and so it’s sort of an evolution of index investing.

[00:29:20] It’s really, it’s, it’s taking what’s great about index investing to another step. And we do need to be careful because if we think about the spectrum, there are, if we go to the furthest end of the active spectrum, there are active investment funds that have value funds that have x, y, Z characteristic.

[00:29:36] And so those are those traditionally managed funds that we would not expect to outperform the benchmark as a whole. So something you need to keep in mind.

[00:29:44] Do Factors Still Work Now That Everyone Knows About Them?

[00:29:44] Evon: Another question that comes up is that do these factors still work? You know, everyone knows about them. The research is out.

[00:29:50] Like are we still expecting them to work? Because we know they show up in the data before the research was done. But do they continue to show up after the research is done and everyone knows about it and active hedge funds and investment managers can take advantage of these characteristics? Well, what we find in the research is that post publication of research, these characteristics, these factors, the premiums they give you still exist.

[00:30:17] They’re still there, but they are diminished. We might expect them to be smaller than they were when looking at the historical research, but they do still exist. And it does highlight how important it is when you’re, when you’re using funds that take these approaches that they both have a good approach to implementation and cost and efficiency.

[00:30:37] Both of those are really important. And there is a difference between underperformance and the factors no longer working. As we talked about earlier, we are expecting periods of underperformance. These characteristics show up cyclically, and we are not expecting them to work at all times.

[00:30:54] If we did, everyone would pile into them and never own the opposites. There’s a difference between periods of un performance and them permanently no longer working. That’s really important.

[00:31:05] How Do We Use and Implement These Factors In Practice

[00:31:05] Evon: so let’s talk about the practical applications, like how do we use this stuff in practice? What do we do with these factors? Well, one of the ways that these factors are used is that they help us to understand what explains the returns of actively managed mutual funds.

[00:31:19] You know, if a manager has X, Y, Z outperformance against the broad stock market as a whole, you can run it through these factors. You can see what explains that outperformance versus the market as a whole? Is it simply because they have exposure to not only the stock market but they have exposure to value characteristics and smaller companies?

[00:31:42] Because if that’s the case, it doesn’t have anything to do with their skill. It’s simply the fact that they are owning more of those characteristics. And if it has nothing to do with their skill, there’s no reason for you to buy their fund and pay the extra fees for that. You can invest in those characteristics passively, right?

[00:31:59] So these characteristics helps help to explain the investment performance of managers to see what’s really due to their skill versus simply to them having exposure to certain characteristics. And, and we talked about in the last episode, there’s a phenomenon of closet indexers where actively managed funds own so many stocks that they look pretty much like the index. They’re basically just mimicking the index, either intentionally or not, and you’re paying those extra costs to simply get the return of the broad market. So those help us to understand where performance actually comes from.

[00:32:35] But another thing goes, going back to our original question, is that we can use these characteristics to tilt towards, to potentially improve the expected outcomes for our investments.

[00:32:47] We can tilt towards these characteristics. We can own a little bit more of the smaller and and valuer and more profitable companies than you might see in a global stock market index fund.

[00:32:58] How Do Optometrists Implement Factor Investing In Their Portfolios? It Takes a Personalized Approach

[00:32:58] Evon: And so how do we actually implement this in our portfolios? Well, this is where, a podcast episode like this really falls short. this is where really your own due diligence or working together with an advisor. Implement this well, based on your personal circumstances make sense.

[00:33:14] Some general guidelines to think about are, are number one, I’m not talking about here, making really highly concentrated bets on any of these characteristics. Like I, I’m not talking about going all in on small companies or all in on value or all in on anything else. The approach that I generally start with when thinking about investing, and you should think about in your own due diligence, is I’ll start with the global stock market index and as I have evidence-based reasons to adjust away from that, or if I have really clear investor preferences to adjust away from that, that’s when I’ll start to adjust or tilt away from that.

[00:33:50] And so I’m talking about starting with owning everything, but just tilting then towards these characteristics and away from their counterparts, owning more of things that are smaller and cheaper or valuer and more profitable relative to what you’d see in a total market index fund.

[00:34:10] It’s sort of like if you have an ice tray and you put that ice tray in flat in the freezer. Well, that’s like owning the whole index in its exact proportions. Well, instead of what I’m talking about is tilting the water, so more of the water ends up in certain corners and less of it ends up in the other corners.

[00:34:27] You’re just tilting towards these characteristics. And some fund families, will create funds that do this sort of all in one. Like it’ll either have the global market and tilts towards these characteristics on that one fund. Or they’ll have a US fund and an international fund and emerging market fund.

[00:34:46] And within those, it’ll tilt towards it. So they’ll take everything that’s great about in index funds and implement this research within those funds. And then you can add on to that if you want to tilt even more. So that’s, that’s one of example.

[00:34:59] Some people will do a more of a core and satellite approach where they’ll have a broad market index fund and then use like an individual small value fund, an individual international small value fund to get the tilts they want. Reasonable minds can debate the implementation. it really comes down to what makes sense for you. I would like you to think about starting with owning everything and then tilting towards all characteristics together.

[00:35:21] And as I mentioned, there’s hundreds of proposed factors out there. And the more that you’re gonna add on, the more you’re, you’re gonna tinker with. And the more you start to tilt away from just the market portfolio, the more you need to be sure that that’s really gonna be adding something to your investments.

[00:35:40] Above and beyond the cost and complexity of adding it.

[00:35:43] And one more thing I’ll add about implementation is that there are index funds that try to invest in things like small value.

[00:35:51] There are index funds that try to invest in, in these characteristics, and a lot of times they’re gonna be tempted to go towards those because they are the absolute cheapest. But what I will say is that if you’re no longer investing in a broad whole market index, costs are not the only factor.

[00:36:07] They’re very important, but implementation is hugely important.

[00:36:12] And so implementation’s huge. Something you wanna keep in mind.

[00:36:15] Which Optometrists Should Consider Factor-Based Investing?

[00:36:15] Evon: So who are the good candidates who should consider using an approach like factor-based investing? Well, number one, it’s someone that has good understanding of what these factors are. You’re working with a financial advisor that has a good understanding of these factors, and you have good expectations of what to expect over time.

[00:36:35] in addition, you can keep up or your advisor keeps up with research around these characteristics and how mutual funds and ETFs actually implement them. Both costs and implementation are really important here.

[00:36:47] You have to have a really long time horizon.

[00:36:49] These are long-term investment characteristics. These are not short-term characteristics. There are going to be periods of time, even uncomfortably long periods of time where these premiums don’t show up. Even stocks have underperformed bonds.

[00:37:02] You’re gonna see periods of time like that, and you have to be willing to stick with this for the long term. And have that ability to not abandon the strategy during those periods of underperformance.

[00:37:11] And we see this with 401(k)s, 401k administrators are short term thinkers. I mean, they look at what’s done well recently, and make adjustments to your fund lineups based on that. And we’ve seen cases, especially in the US where these factor funds in the US have been pulled off and replaced with just broad market index funds because of that short term performance and clearly those administrators didn’t understand the reason for adding those to the fund lineup in the first place.

[00:37:36] we’ve seen Roboadvisors, certain robo platforms do the same thing. And so you have to have good expectations and have a long-term time horizon.

[00:37:42] And, and then lastly, those who just appreciate evidence-based approaches to investing, similar to evidence-based Optometry

[00:37:49] Which Optometrists Aren’t Good Candidates For Factor Investing, and Should Stick With Whole-Market Index Funds?

[00:37:49] Evon: so who shouldn’t use factor-based investing?

[00:37:52] Who should stick with just broad market index funds? Well, number one, if you prioritize ultimate simplicity and if you just want to invest in the broad market and keep it super simple and not need to think about anything else, you don’t wanna think about any of these definitions or research or any of this stuff.

[00:38:10] Broad market indexing can work well for you. I think that’s the approach that probably makes the most sense for you.

[00:38:16] Number two, those who aren’t able to handle looking different than the market. if you are constantly benchmarking the day-to-day or short-term interactions of your investments versus some index like the S&P 500 or the Russell 3000, like if you’re constantly going to be comparing your investments towards the index and constantly be upset about that, this probably isn’t going to make sense for you because if you’re using these factors, you are choosing to look different than the market. And a big risk is that your returns are gonna look different from the market. There’s going to be periods of time where it will perform well and times where it won’t. And you have to be able to just ignore those differences.

[00:38:55] and if that’s gonna cause you constant stress, then this approach probably isn’t gonna make sense for you. Just invest in the index.

[00:39:01] And then number three, those with very short time horizons, right? Again, this is a long-term investment approach. and if you have a very short time horizon, even the amount of stocks that you own in general is a really important decision.

[00:39:12] Final Thoughts – We’ll See You On The Next Episode!

[00:39:12] Evon: So hopefully this is helpful. I’m not sure if I’m going into too much weeds here. This is sort of touching on a generalized overview, some final thoughts. Factor investing isn’t about abandoning passive investing principles. It’s taking a lot of the same research that leads to index funds, to its further conclusions taking.

[00:39:32] What’s great about indexing. Taking it to a next step. But it takes a disciplined long-term approach.

[00:39:37] One reason I wanted to talk about this in episode just to expose you to the idea that there is simply more to the story than you typically hear. Very often if you spend any amount of times in these online groups. The idea of just investing in the S&P 500 and nothing else is commonly thrown out.

[00:39:54] I just wanna expose you to the, to the facts, really to the data that there is, there’s more to this story. I consider that a very active investment decision to only invest in only the largest companies in only the United States. You are tilting, as we’ve talked about earlier, you’re tilting away from all other corporations in all other countries as well as the us.

[00:40:17] And does that make sense from the data to own primarily the growth largest companies in the United States. As we’ve seen in this conversation, well, not necessarily, it worked well in the last 15, 10, 15 years, but historically, and especially when you look across the globe, that’s not necessarily the case.

[00:40:37] I just want to expose you to the idea that there’s more to the story here. There are ways to improve, potential outcomes with your investments in ways that are not falling into the trap of trying to be this really active trader.

[00:40:51] And are based on evidence in academic research and as much of, of a scientific approach as we can get. So again, hopefully this helped. Stay tuned. I’ll be tackling other common investment topics I see come up a lot, like, should you prioritize dividends in investments?

[00:41:07] Are individual bonds safer than bond funds? These are common questions and sometimes misconceptions that I’d like to tackle here.

[00:41:14] And check out the show notes all sorts of resources about this topic that you can dive into for further learning. If you have any questions, please reach out to me at podcast@optometrywealth.Com, or schedule a time to chat. if you don’t want to hear about investments anymore and you find this just isn’t helpful, let me know that as well.

[00:41:30] I’d be interested to hear that too. if you found the podcast helpful, please leave a review, share it with your peers. And then lastly, if you wanna learn more about this, about tax planning, about student loans, practice finances and more, you definitely want to sign up for My Weekly Eyes on the Money Newsletter.

[00:41:46] Well, I write about all of these things in a short form that you can understand each and every week. And with that, really appreciate your time and attention. We’ll catch you on the next episode. In the meantime, take care.

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