Readers of financial literature are aware of the Fama-French Five-Factor Model (Beta, Size, Value, Profitability, and Investment). DeMuth’s short article gives one a flavor of the five-factor model and if you are looking for more details, go to this link and download the Fama-French article. It is difficult to employ beta, profitability, and investment if one is using ETFs to populate the portfolio as those three factors are better identified through individual stock screen searches.
Here at ITA we use two of the five factors, size and value, and add two additional factors when constructing portfolios. The third and fourth factors are momentum and correlations, something we identify through the use of the Cluster Weighting Momentum model. The four factors are explained in more detail below. The importance of matching low correlated securities is underscored in Larry Swedroe and Kevin Grogan’s new book, Reducing the Risk of Black Swans: Using the Science of Investing to Capture Returns With Less Volatility. This short (66 pages) book explains correlations with understandable examples.
Size: Portfolios are skewed toward mid- and small-cap value by using VOE and VBR to a greater degree than one might find in a portfolio that emulates the S&P 500. Not long ago I published results showing mid-cap value (VOE) has been a top performer over the past ten years. ITA portfolios carry a higher percentage of small-cap stocks than one finds in the VTSMX index fund. Emphasize small size when building a portfolio.
Value: Value is identified as stocks that have a high Book/Market ratio. Value is sometimes stated as low Price/Book/Share. Once more, ETFs that occupy this space are VTV, VOE, VBR, Large-Cap Value, Mid-Cap Value, and Small-Cap Value respectively. Holding large percentages in VOE and VBR immediately cover two of the five factors identified as important to improving portfolio returns. In fact, beta, size, and value contribute approximately 90% to a portfolio return leaving little room for individual stock selection or market timing. Emphasize value when building a portfolio.
Momentum: ETFs that have performed well over the past three months tend to continue to perform well over the next three to six months. This factor is difficult to explain other than human behavior. We plan to continue to employ this factor so long as it works. Within the momentum factor we attempt to control risk by selling ETFs when they under-perform SHY and/or dip below their 195-Day Exponential Moving Average (EMA). Emphasize momentum when building a portfolio.
Correlations: Holding low correlated ETFs is one of our primary tools to reduce portfolio volatility or risk. Correlation analysis is carried out using the Cluster Weighting Momentum spreadsheet as well as the Hoadley Correlation Analyzer spreadsheet. Use low correlated ETFs when building a portfolio.
These factors, size, value, momentum, and correlation are the four cornerstones when it comes to building a solid retirement portfolio. Watch how this factors are used and what tools are required to implement them as the various portfolios are reviewed and updated.