Factor and smart beta investing are "rapidly" displacing traditional stock picking, according to a new Research Affiliates paper.
"Traditional active management of equity mutual funds has delivered returns persistently below passive benchmarks," says the paper by the Newport Beach, California-based firm, which specializes in smart beta. "In contrast, many factor-based smart beta strategies have persistently outperformed the same capitalization-weighted benchmarks."
In the paper, "A Smoother Path to Outperformance with Multi-Factor Smart Beta Investing," Chris Brightman, Vitali Kalesnik and Feifei Li of Research Affiliates examine how one can outperform the market with substantially lower relative risk by diversifying across simple smart beta strategies based on a half dozen robust factors.
"You can outperform the market by investing in factor-based smart beta strategies, and you can obtain this outperformance with a smoother ride — that is, with substantially lower tracking error and shorter periods of underperformance — when you invest in a diversified portfolio of smart betas," the paper states.
Here's how:
1. Stick to These 6 Factors
Researchers have identified more than 300 distinct factors that purport to predict equity returns, and the number grows every year. Research Affiliates narrowed that number down to six factors that provide an opportunity to outperform the market.
"Our research leads us to conclude that only a handful of factors represent genuine future return opportunities — strategies with the potential to outperform in the decades ahead," the paper states.
Those six factors that Research Affiliates identifies are value, profitability, investment, size, low beta and momentum.
All six factors demonstrate both statistically and practically significant returns.
The average annualized factor return in the United States over Research Affiliates' study period (July 1973 to September 2016) was 4.86%.
"The prospect of an average annualized excess return of nearly 5% across six robust and largely independent factors helps explain the strong investor demand for factor investing," the paper states.
Research Affiliates also finds that the correlations across these six factor returns are predominantly low or negative, which suggests they are independent and thus able to provide strong diversification benefits.
2. Diversify Across Factor-Based Strategies
