Many investors today are confronting what could be considered a “perfect storm” that is creating strong head winds against the pursuit of higher expected returns. So far, we have discussed the main factors currently working against investors, as well as some steps they might consider taking to help combat this problem. 

We will now examine why increasing your exposure to certain investment factors not only can provide higher expected returns and a diversification benefit, but also can help mitigate risk.

They’re Called Risk Assets For A Reason

Before we continue, however, there’s an important warning to heed. Because none of us has a clear crystal ball when it comes to predicting the future, the diversification of risks should be the guiding principle in many investment decisions. Thus, all decisions should be made “in moderation.”

For example, while we mentioned a good starting point for holding international stocks is 50% of your equity allocation, I would be very cautious about having that allocation exceed 60%. And with emerging markets making up about 12.5% of global equity markets, I’d be very cautious about allocating more than, say, 25% of your equity allocation to that asset class.

You also should be very sure that you will be able to “stay the course” during the inevitable long periods when all risky assets will perform poorly. No asset class that is risky is immune.

A good example of the risk of tracking-error regret is the period 2003 through 2014. From 2003 through 2007, the S&P 500 Index returned 12.8%, the MSCI EAFE Index was able to return 22.1% and the MSCI Emerging Markets Index returned 37.5%.

Then, from 2008 through 2014, while the S&P 500 Index returned 7.3%, the MSCI EAFE Index returned 0.0% and the MSCI Emerging Markets Index managed a -1.0% return.

Long and unpredictable periods of underperformance (when tracking0error regret will rear its ugly head) are why I believe that, while it’s OK to “sin” (have more than a market-cap weighting to an asset class), it’s best for most people to sin only a little. And make sure you understand fully the nature of the risks you are taking, and be prepared to live with the consequences of your decisions.

This warning—to “sin only a little”—also applies to our next opportunity for increasing expected returns. The academic research has provided investors with strong evidence that there’s a small group of factors (sources of returns) that have provided higher returns. To be considered in this group, the evidence must have the following characteristics:

• Persistence—it must hold across long periods of time and various economic regimes.
• Pervasive—it must hold across countries, regions, sectors and even asset classes.
• Robust—it must hold for various definitions (for instance, there’s a value premium whether we measure value by price-to-book, earnings, cash flow or sales).
• Investable—it must hold up not just on paper, but also after considering trading costs.
• Intuitive—there must be logical risk-based (economic) or behavioral-based explanations for the premium and why it should continue to exist.
• It must not be subsumed by other well-known factors.

While there have been more than 300 investment factors identified—so many that John Cochrane called the situation a “factor zoo”—there are only a handful that meet these six criteria.

Factor Investing

In my view, there are three equity factors (not including the market factor) that meet these six criteria: size (small-cap stocks), value and momentum. From 1927 through 2014, the market factor (beta) has provided an annual average premium of 8.4%, the size factor (the return of small-caps minus the return of large-caps) has provided an annual average premium of 3.4%, the value factor (the return of value stocks minus the return of growth stocks) has provided an annual average premium of 5.0%, and the momentum factor (the return of positive momentum stocks minus the return of negative momentum stocks) has provided an annual average premium of 9.5%.

All else equal, increasing your exposure to these factors will increase your expected returns. Let’s take an example. The Vanguard Small Cap Value ETF (VIOV | B-90) and the DFA Small Cap Value Fund (DFSVX) are both similar, passively managed small value funds. But over the 15-year period ending Nov. 11, 2015, DFSVX returned 11.0% and VIOV returned 9.7%.

The explanation for this discrepancy lies in the fact that the stocks DFSVX holds are smaller and more “valuey,” meaning they have smaller market caps and lower price-to-value metrics, such as price-to-earnings, book value and cash flow. Stocks held in the newer but still passively managed Bridgeway Omni Small-Cap Value Fund (BOSVX) have even smaller market caps and lower price-to-value metrics. Thus, it has even higher expected returns. (Full disclosure: My firm, Buckingham, recommends DFA and Bridgeway funds in constructing client portfolios.)

Similarly, for the same 15-year period, while the DFA Emerging Markets Fund (DFEMX) returned 8.5%, the firm’s Emerging Markets Small Cap Fund (DEMSX) returned 11.4% and DFA’s Emerging Markets Value Fund (DFEVX) returned 10.5%. The greater exposure of these latter funds to the small and value factors again explain their higher returns.

Thus, if you increase your allocations to these factors, without increasing your overall equity allocation, all else equal (costs must be considered) you’ll increase the expected returns of the portfolio. However, there’s another important benefit of factor investing. The correlation of returns to these factors is relatively low, which provides a diversification benefit. Because of these diversification benefits, in my view, this is the least risky way to increase expected returns.

While increasing your exposure to these factors will increase the expected returns of the portfolio, as well as providing a diversification benefit, there are actually two ways to use these resulting higher expected returns. We’ve focused so far on only one—raising the expected return of the portfolio.

Employing Factors To Reduce Risk

The focus of my book, “Reducing the Risk of Black Swans,” which I co-authored with my colleague, Kevin Grogan, is to show that there’s a second way to use the higher expected returns from these factors.

Because of the aforementioned diversification benefit, adding exposure to these factors historically has raised expected returns by more than the increase in the risk of the portfolio. The result has been a more efficient portfolio, one with a higher Sharpe ratio.

However, increasing the higher expected returns to these factors can also be used to lower the exposure to the risk of equities (beta) in a manner that keeps expected returns the same. Then, because of the diversification benefits, the volatility of the portfolio also is reduced, without lowering the expected return.

In addition, if only safe bonds (such as Treasurys) are used, the left-tail risk (the risk of Black Swan events) will be reduced by a greater amount than the cut in right-tail opportunity. Again, the result is a more efficient portfolio.

Summarizing what we have discussed so far, you can raise the expected return of a portfolio by: increasing the equity allocation; increasing your allocation to international developed-market stocks and emerging market stocks; and increasing your exposure to the three factors of size, value and momentum. It’s important to note that these concepts aren’t mutually exclusive. You will have the largest impact on the portfolio’s expected returns if you use them all in combination.

Today the highest expected returning portfolio would be to own only emerging market small value stocks. However, I wouldn’t recommend that to anyone. Remember that in a world of uncertainty and unclear crystal balls, diversification is your best friend. If you want some of the highest expected returns, and are willing and able to accept the higher risks associated with such a portfolio, than I would recommend you consider what The New York Times called the “Larry Portfolio,” which is basically a globally diversified portfolio of small value stocks. This strategy is also discussed in detail in “Reducing the Risk of Black Swans.”

Next time, we’ll examine some other advanced planning options investors may consider for increasing expected returns. And while we’ve so far covered a number of strategies to give expected returns a boost, later this week we’ll take a look at some of those better avoided.

This commentary originally appeared December 23 on ETF.com

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