And Rick had 35 years as a financial advisor. He is a recognized champion for low investment fees. I view him as the Jack Bogle heir apparent in a lot of ways. But he's a pioneer in low-fee investment advice and portfolio management. He's authored seven investment books, hundreds of articles, been published all over the place.

He's got a Master of Science in Finance from Walsh College. He's also a CFA charter holder and he's a marine. There's no such thing as a retired marine or an ex-marine. He's a marine. He flew jets for the Marines for 21 years. >> Thank you. Me, the case against factor investing.

Okay. I was asked to do this. And I told Paul, I don't really need 20 minutes, probably five. So here we go. Okay. Now, I'm going to describe what I put up here next. So the bullet points will come up and then I'm going to talk about them. So you don't really have to look at them on the screen.

But here's the reality. And that is, number one, this is just some basic stuff about the markets and the stock market. Market beta, the return of the entire market, explains most of the return of every diversified portfolio. There've been several studies on this, several famous studies. Eighty percent of the return of your diversified portfolio of stock.

And they use stock portfolios, the academics that did this, 100 stocks in each portfolio. So just mixed them all up, individually selected 100 stocks, 50,000 tests of this. The bottom line is, 80 percent of the return or the variability of any of those portfolios was based on the return of the market.

So it doesn't matter how much small value, large growth, whatever you put in your portfolio, beta, or the return of the market, is going to drive more actually than 80 percent of your stock return. Whether it's small value or large cap, or small cap or value or whatever, is going to drive a small portion of it.

These things are called factors. And Gene Fama, Nobel Prize Laureate Gene Fama, I interviewed him for a blog one time, and he called them additional factors. And what that meant is that in addition to the 80 percent that explains the return of any portfolio, any diversified stock portfolio, about 20 percent or less will be explained by these other factors.

And that is the amount of stock in that portfolio that is small relative to the market, the amount in that portfolio which has more value stocks relative to the market, the amount in that portfolio that has more quality stocks, price momentum stocks relative to the market, is going to explain a very small portion of the return of the variability of those portfolios.

Those are called additional factors. Now, some people call it smart beta. I mean, there's a lot of marketing terms for this. That makes up the rest of the portfolio. So in the end, what is going to drive your portfolio return is beta. Beta is driving your return, and factor investing is sort of, I don't know, the color of the flavor of the sprinkles that you put on your ice cream, okay?

Now, most of the weight to additional factors, this will determine what's called the tracking error, the tracking error of your portfolio to the market. So if you have more value stocks, you have more quality stocks, you have more momentum stocks, you have more of these factors in your portfolio, the return will track the return of the market, but it might be more, which is the premium that Paul is hoping for, or it could be less, and that's a negative tracking error, which was what we've seen for the past almost 20 years, negative tracking error.

So a factor-tilted portfolio, so what I'm doing here is I'm going over some semantics. The factor-tilted portfolio means you are starting with the base portfolio of the market, a total stock market index fund. I know all the poor old slides were talking about the S&P 500 versus small value and all that.

That's great for the presentation that he made, but I don't start with that. I start with the Vanguard total stock market index fund, which has small value in it, and it has everything else. So you're going to get a factor-tilted portfolio. You start with a total stock market, and then you decide how much load you want to add to it, to small cap, how much to add extra value, how much to add in momentum stocks, how much to add in quality stocks, these other additional factors, and then that will determine your tracking error to the market over the long term, that other 18%.

So now, the presumption with Paul's slides that go all the way back to 1926, which I'm sure that you were all investing since then, the factor premiums have been positive. I'm not going to argue with math that Paul put up there as far as the factor premiums. I will say that if you looked at the slide where he showed the factor premium, which was one of his first slides, it took large cap value minus small cap value.

In other words, it's a long-short strategy, long-short. So you're going to go long, say, large cap growth stocks and short, small cap growth stocks to find out what the premium is on small cap growth. You go long, large cap value versus small, minus small cap value. So you get, it's a long-short strategy.

So really, if you're just going long, if you're just a long-only investor, you got to cut everything in half. In fact, it's less than half. I talked to Wes Gray, who has a PhD from the University of Chicago, and the upside premium is actually less than the downside premium.

But anyway, I don't want to get into the math of it too much. The bottom line is, if you invest in these factors and that premium is not positive, it's less than zero, then you're going to have negative tracking error to the market. Your portfolio will underperform the total stock market index fund.

It will, which is what we've seen for a long time. So the only way that you could make money using a tilted strategy is to be in it long enough, and Paul said 17 years. Wes Gray and I discussed this, and it's more like 25 years. You have to be committed to a factor-tilted portfolio for probably 25 years to have a fairly high probability that you will actually get the factor premiums.

Takes that long. And if you are going to commit to that 25-year period of time, and you want to do this strategy, okay, it's not gonna make that much difference, but if this is what you want to do, you have to stay for the long term. You gotta get over that, what's called the hurdle rate, and the hurdle rate, by the time you have to, I'm sorry about that, one second.

You gotta get over the hurdle rate of the underperformance and the fees. By the way, small cap value, everything else, beta is free. You can go out and you can buy beta, the total stock market index fund. I don't know if you've done a comparison of the total stock market index fund return that Vanguard has to the total stock market index, but they do a few things in the portfolio that I'll be talking about tomorrow with Jerry O'Reilly, who's the portfolio manager of that fund, that actually makes up a few basis points in the total stock market index fund where you are actually getting the return of the total stock market, even net of fees.

So beta is free. Factor investing is not free. You will pay fees. The fees have come down. You can get a small cap value fund relatively cheap. Problem is it doesn't have high loadings to small cap value, 'cause the cheaper you get, it seems like the less the loadings to the value are.

In other words, loadings are how much of that fund is allocated to small cap value and how much is allocated to maybe mid cap, mid cap value and so forth, which is a little bit diluted. And so you get something like a Vanguard small cap value fund, it tends to be lower fee, but it's also not high loadings to value factors.

I know we're talking, but this is the advanced group, right? Right, okay. Anyway, okay, 501, this is 501. Now you can then say, well, okay, I want to look at these small cap value funds based on a different metric, and that is my cost per unit of risk. And when I'm talking about risk, I'm not talking about beta, you X that out.

I'm talking about what does it cost me to get the exposures to small cap and small cap value? Is it a very deep small cap value fund? It's probably better if you're actually gonna do that, better to have that fund, because you'll find that when you look at the fees, they're not that much higher than the less potent, if you will, Vanguard fund.

So the cost per unit of risk for the more potent fund would be better. So I'm just saying that if I was gonna do small cap value, I would buy the most potent small cap value fund I could find, even though the fee is gonna be a little bit higher.

But the point is, there's always fees. 25 basis points, 30, 35, a lot higher than the total market. That's the hurdle rate you have to get over. You have to make that up before you're gonna outperform, and if you don't make that up, then you're gonna underperform. And how have we done?

All right, this seems to be a real interesting thing, phenomenon that happens in the academic world. It's that when academics come out with a new study, and it gets published, and you find out that small cap stocks back in 1980, the study that was done in 1980, small cap stocks outperformed large cap stocks.

Wow, that was published, all of it, and by the way, at the same time, small cap mutual funds started to become very, very popular. Lots of people investing in small cap. What happened? Since 1980, no more premium, no more premium. Okay, what about value versus growth? Now, there's a million different ways in which you could do value.

Like Paul said, there's different value indexes. That's true, value is in the eyes of the holder. You could use price to book, price to sales, return on equity, enterprise value, on and on and on, a million different ways in which you could create a value fund. So value is in the eyes of the beholder.

How have value stocks done relative to growth stocks since the big study on this came out in basically the early 1990s, the Palmer French study? And the answer is, not that great. What's going on? Are the academics wrong on this stuff? No, they're smart people, very smart people. They went back into the data and they dug out all this information and they said, if you were doing this back in the day, you would have achieved higher rates of return.

Larry has this great book and Larry and I discuss a lot of things. And, but I mean, he's a really a fine researcher himself and he wrote this book called, co-wrote it with, Your Complete Guide to Factor-Based Investing. It's a great book. I really like his, this book. It's very good.

And Larry has a library of over 3,000 different articles that were, or studies also that were done on factor investing, the so-called Factors Zoo. The Factors Zoo. There's literally 300 different factors that make up that 18%. They call it the Factors Zoo. In his book, he cites 106 of these different factors.

Oh, they're out there. You can go back test to your eyes water. You know, you can find all these things in, back in history before people knew about it. And you could create a study and say, you know, if you actually did this, you know, you would have outperformed.

So, you know, are the academics wrong? No, they're not wrong. They're very good at going back and looking at past data. Very good. What is the problem? Anybody ever see this photo? This is amazing photo. That is Leonardo da Vinci and Mona Lisa. This photo was taken in Florence in 1504.

What are you laughing for? What's wrong with it? It didn't exist. Of course, cameras weren't invented until the early 1800s. So how could this photo exist? It was back tested. It's a hypothetical photo. But I bet if there actually were photographers back in 1504, that that picture probably wouldn't have been taken because Mona Lisa and that whole thing wasn't even popular back then.

So in other words, same thing with back testing. If you would have known, if you would have known that these things actually were gonna perform like Paul said, would it have changed the world? The answer is yes. Of course it would have. If people actually knew that small cap is gonna outperform large cap, they would have invested in small cap.

These institutional managers have to perform. It's their job. If they knew that value was gonna outperform growth, of course they would have invested in it. What would that have actually done to the real world data? It would have changed it. We in a period now where since all this academic information is now out there, that maybe the world has changed.

Maybe we're not gonna see these premiums going forward. Something you're gonna have to decide. But there's another issue besides the data and that is behavior, us, our bad behavior. So factor tilts create what I call a behavioral risk. It's a behavioral risk that occurs when you're not holding the stock market.

You're not holding the market. You're holding something else. Why are you holding that other thing? Why are you not holding the market? 'Cause you want to outperform. You wanna beat the market. That's why you're investing in factor funds. How long will you last? That's the question. From 2000 to 2007, after the tech stock bubble exploded, small cap value stocks had their best run, I think, ever, and Paul, you can correct me on this.

I was in the money management business at the time. I had a money management shop. I got hundreds of phone calls from people. How do I get DFA funds? How do I get DFA funds? Will you put me in a portfolio with DFA funds? Everybody wanted DFA funds because they were the ultimate farmer, French three-factor model, small cap value investment management firm at the time, and everybody wanted access.

And the only way you could get access to DFA funds at the time was to go through an advisor, and most of the advisors were charging 1% or more to have that access. So I was getting these calls all the time, and I said, "No, we're not gonna do that.

"We really don't believe that. "We can put a small amount in, "but we may not even use DFA. "We may use something else "that's a little cheaper than DFA," whatever it was. It was a flood of people. But you'll probably hear this tomorrow from Charlie Ellis. There's something in the markets called regression to the mean.

And what happened? Well, we had a long period of underperformance. Since 2007, small cap value and factors in general have underperformed the market significantly. Let's see, it's 2023 now. So what is that, 16 years, 17 years, roughly? Weak hands have already thrown in the towel. You're trying to beat the market.

That's why you did this. Come on, right? That's why you do small value. You're trying to beat the market. How long are you gonna hang in there? 17 years, 15 years, 10 years? How long you gonna give it? Most people, a lot of people who contact me, and I do that hourly model now, they've already thrown in the towel, or they wanna throw in the towel.

They're done, especially as you get older. I mean, you know, I'm on Medicare now. The last thing I want is complexity in my portfolio or things that have underperformed. So anyway, so the performance-chasing mentality or the performance-chasing mindset that got people into factor investing to begin with isn't really factored into these studies.

They talk about the premiums that they delivered since 1928 or '26 or whatever the year is, but they don't talk about the mental aspect of it. In the long periods of time in which there's this drought of returns where people who got in during that I-gotta-have-DFA period have already thrown in their hand, and guess what?

They, guaranteed now, are gonna underperform the stock market since inception, guaranteed, because they have no chance of making that back if small-cap value actually comes back. Therefore, I'm gonna tell you something John Bogle said. John Bogle was way advanced, way advanced on this stuff. He said, you know, it's a lot easier in life over your retirement to just hold the stock market, just hold the whole market.

I mean, people are okay holding the market. You allocate a certain amount to the market, you own an index fund that owns the whole market, and you're done, it's easy. You can do that. As factors, much, much more difficult. So Rick's bottom line on all this. You could be rewarded for adding additional factors to your portfolio in the long term, but those premiums may not be guaranteed.

They may be a lot smaller, or maybe they've gone away entirely. The only guarantees that you will have is you are taking a risk when you do this. You are taking a risk that you're not gonna get a market return. You're also gonna pay more. You're also making your portfolio more complex, and the tracking error to the market, if it goes on for a long enough period of time, you may decide to blow out, and now you've permanently locked in on the performance relative to the total stock market return.

If you are in, okay, so here's my advice to the people who are already doing this, Paul. Okay? (laughs) Stay in. You've got sunk cost. I mean, you've been in it, you've been losing, it's been underperforming. I mean, it's hard, okay? But you've got sunk cost, so you really need to stay in this thing, okay?

If you're thinking about adding additional factors, I say limit your exposure to 25%, and what do I mean by that? You have a total stock market of 75, and then you do a very heavily concentrated portfolio of no more than 25% of small cap value. And you need to do it for a very long period of time, probably the rest of your life, and that may not be long enough.

In fact, Paul was saying he put it in his, what was it, your granddaughter's account? Is that what it was? (laughs) So remember, the most important decision we make, so let's get back to basics, the most important decision we make as investors with our portfolio is your beta allocation, your beta allocation.

How much stock market beta are you going to have? How much bond market beta are you going to have? Jim Dolly gave the presentation about real estate, which would include your home. How much of that beta would you have? How much cash would you have? And then let the markets do their thing.

If you wanna do small cap investing, small cap value investing, it's not important. I mean, it becomes increasingly unimportant the older you get. So this is something that it's hard to talk the talk and walk the walk. I always love this. This is factor investing. It's hard walking on this stuff.

It is. It's hard to swallow 17 years of underperformance. And what is the bottom line? What is the risk? What is the biggest risk of factor investing? I don't think it's the fact that these premiums may or may not happen again in the future. I mean, I think that if enough people blow out of these factors, which it seems like maybe, I mean, the spreads between value and growth just keep on getting bigger and bigger and bigger and bigger and bigger.

Every year I hear the value people say, hey, hey, look at this, look at that, look at the spread. I mean, value has never been cheaper. We have except for next year, it gets cheaper. The year after that, it gets even cheaper. Okay? So if you're gonna do it, you need to do it for the long run, you need to stay in it literally for the rest of your life.

I mean, it is a 25 year at least commitment to try to get these premiums. And that's me, that's my presentation. Thank you. (audience applauding) - Thank you, Rick.