Real world factor tilting returns vs. theoretical

[PathtoFIRE]

https://www.researchaffiliates.com/en_us/publications/articles/604-the-incredible-shrinking-factor-return-unabridged.html

I just perused the above article, and find the research interesting. Many of us have heard of factor tilting, usually in the form of small cap, value, momentum, etc. I initially carried a small cap tilt in my portfolio myself (first through holding mostly DGEIX which builds it in, then once I diverted all new money into Vanguard I outweighted the small cap and extended market funds available in my 401k), but now I strive to keep around a 73/18/9 large/mid/small ratio across my entire portfolio (which does require me to slightly outweight small and mid in my 401k to offset some other accounts as well as my international funds in general which only give me exposure to mostly large caps), which mimics VTSAX's allocation.

The siren call of factor tilting is very strong, since it is so easy, it can be done through low cost indexes for the most part, and the historical advantages seem clear for theoretical portfolios. However, I think the papers above raise some very plausible points that the various trading and implementation frictions significantly reduce and in some areas completely negate the excess return from factor tilting when using live portfolios.

[RichMoose]

Factor tilting is just a new version of active management. As investors pour into smart beta products, often at the recommendation of professional managers, I think they are putting themselves at significant risk of future underperformance.

On the bright side, it's much cheaper to pay a MER of 0.5 - 1.0% for factor-based funds than paying 2%+ for active managed funds, but the danger lies in the publicized rules that relate to smart beta products. This sets up a trader's dream: front-running.

[MustacheAndaHalf]

I believe OP is referring to funds like Vanguard Small-Cap Index, which offers an expense ratio of 0.08%.  Vanguard "Small" Cap's holds companies with a median market cap of $3.7 billion.  Some definitions of "small" lump about half of it into mid-caps (see morningstar.com for example).

[RichMoose]

I believe OP is referring to funds like Vanguard Small-Cap Index, which offers an expense ratio of 0.08%.  Vanguard "Small" Cap's holds companies with a median market cap of $3.7 billion.  Some definitions of "small" lump about half of it into mid-caps (see morningstar.com for example).

Yes, size factor is one of the factors discussed.

Read the entire paper, it looks at several popular factors. Some carry higher costs than others. Not surprisingly, the most successful factors relative to broad index seem to be those with the lowest turnover when implemented.

[MustacheAndaHalf]

Factor tilting is just a new version of active management. As investors pour into smart beta products, often at the recommendation of professional managers, I think they are putting themselves at significant risk of future underperformance.

On the bright side, it's much cheaper to pay a MER of 0.5 - 1.0% for factor-based funds than paying 2%+ for active managed funds, but the danger lies in the publicized rules that relate to smart beta products. This sets up a trader's dream: front-running.

The Fama-French 3 factor model was introduced in 1993, not recently as you claim.  That model contained small and value premiums.  Also note the paper doesn't claim underperformance compared to the market, but compared to the academic predictions of performance.  Investing in small cap and value still beats the market, according to this research paper, it just doesn't beat the market by as much as expected.

The paper does not list specific funds.  There are various funds allowing access to factor tilts (small or value or momentum) costing less than a 0.50% expense ratio (like Vanguard's, which I mentioned earlier).  Smart beta funds have not been around for 25 years, so this particular article doesn't focus on them - it uses ~25 years of data from any funds matching it's criteria (A shares, no load, institutional).