By: Dividend Sensei
But what if there was a way to have your cake and eat it too? I’m talking about a strategy of passive investing, through low cost ETFs, that wouldn’t just match the market’s impressive returns over time, but actually beat it? Well such a thing does in fact exist. It’s called factor investing, or “smart beta”. Here’s how it works.
Market studies spanning over half a century have shown there are five long-term proven strategies to beat the market.
- smaller size
- equal-weighting (vs. market cap weighting like most indexes do)
- dividend growth
- low volatility
- value stocks
The idea is that each of these strategies will counter the weaknesses in a standard index fund and thus outperform it. For example the S&P 500 is market cap weighted, meaning that if you invest in an S&P 500 ETF or mutual fund your money is predominantly going into the largest, most popular, and often overvalued stocks. Equal weighting on the other hand means that your money is more evenly spread out and thus you avoid overweighting in stocks with stretched valuations. Similarly value stocks, dividends stocks, low volatility stocks, all generally share similar characteristics that allow them to outperform the broader market over the long-term.
For example between 1963 and 2017 a portfolio of value stocks would have crushed the market, outperforming by 44% a year on average. Similarly a low volatility portfolio would have beat the market by 6% a year, while generating far superior risk-adjusted total returns. A 50/50 mix of both strategies would have beaten the market by 26% a year on average, generated better risk-adjusted returns, and been a superior choice to the market 36 out of 54 years (67% of the time). Ok but that’s over 54 years. What about more short-term performance? After all if you are in your 50’s or 60’s then you might not have half a century for these strategies to play out. Well over just the last 17 years factor investing has proven to be even more effective, including during a time when we’ve had two 50+% crashes.