Do the standard, momentum, low vol, and dividend progress methods beat the market?

Few buyers would say “no” to beating the market. Even probably the most passive amongst us would fortunately filter-feed a number of additional quid – like a monetary blue whale – if we didn’t want an ‘edge’ to make it occur.

Final week we checked out one strategy to doubtlessly try this. The small worth technique has earned a 2% annualised premium versus the market over the long-term. Outdoors the US, small worth has overwhelmed the market by 1.5% annualised since 1990. Which is simply as effectively, as a result of it’s had a torrid time towards the S&P 500 these previous 20 years.

However different systematic market-beating methods can be found!

The solid of credible candidates consists of:

• Momentum – You purchase latest winners, promote latest losers
• High quality – Corporations with excessive return on fairness, low debt, and steady earnings progress
• Low volatility – Low beta shares that don’t fizz or fizzle as violently because the market. The draw right here is the potential for superior risk-adjusted returns

We will put money into any of those methods utilizing an ETF, they’re backed by impartial analysis, and the dangers are fairly effectively understood.

However how effectively do they really work? If in actual fact they do…

Are there any diversification advantages available in case you mix the methods?

Let’s flip to the info!

Whereas we’re at it, let’s take a look at the dividend progress / chief / aristocrats technique, too. Dividend progress shouldn’t be broadly thought of to be a market-beating wheeze however we’ve got the numbers, so let’s see.

Investing returns sidebar – All returns quoted are nominal complete returns. US information is from the astounding Simba’s backtesting spreadsheet and compiled by members of the Bogleheads to additional public information of investing. World information is quoted in GBP and is from the spiffing justETF.

Market beat-’em-up

Which methods socked it to the market over the longest comparable timeframe?

Right here’s our contenders’ annualised returns versus the S&P 500 for the 40 years from 1985-2024:

US shares solely. USD returns. Small worth and small cap included for comparability functions.
The Sharpe ratio is a measure of risk-adjusted returns. Increased is best.

On these numbers momentum appears like vital.

That’s not too stunning. The long-short model of the momentum technique stands out as probably the most worthwhile of the so-called threat components in educational literature. And right here we are able to see {that a} long-only iteration has delivered a 2% premium within the all-important US market.

Furthermore, my numbers (not tabulated) present momentum’s volatility is fairly regular for an fairness holding. Volatility averages 19.3% throughout the interval.

Additionally-rans value operating

What about our different belligerents?

High quality additionally appears good. It beat the market by 1.2% per 12 months on common. That can add up. Once more there’s no signal you should endure sickening volatility to snaffle the extras.

The most important shock to me is dividend progress. Excessive dividend shares are routinely discovered by teachers to lack any particular sauce. However the technique has topped the market by a commendable 0.7% over the interval we’ve got information for.

Dividend progress additionally delivered the perfect risk-adjusted returns. That’s, you bought extra bang in your buck per unit of threat taken (as measured by volatility).

Low volatility didn’t beat the market nevertheless it isn’t meant to. A low volatility technique touts superior risk-adjusted returns versus the broad market – and on that rating, it delivered.

You would possibly consider low vol because the antacid of fairness methods. It gives reduction towards stomach-lurching drawdowns with out sacrificing an excessive amount of return.

Lastly, small worth and small cap had been poor over this time horizon. But when that encourages you to write-off small worth then I’d urge you to learn our latest musings on small caps first.

Time trial

Let’s cut up aside the 40-year timeframe. Doing so might reveal additional nuance:

Firstly, we are able to see that none of this lot laid a glove on the S&P 500 these previous 5 years.

Don’t hassle with threat components until you’re ready for the lengthy haul. In the event that they beat the market on a regular basis, then they’d cease being threat components. The important thing phrase is threat.

With that stated I’ve highlighted momentum as a result of it’s the one issue that’s constantly overwhelmed the US market throughout each timeframe past 5 years.

High quality has been extra erratic – whereas it’s a must to push your view again no less than 25 years earlier than dividend progress bests the S&P 500.

Well timed reminders

The desk exhibits how contemplating completely different time frames can affect our view. For instance, low vol and small worth would look fairly scorching proper now, if all we needed to go on was 25 years value of returns.

Is there something particular about this quarter-of-a-century mark?

Properly, the broad market nose-dived 38% in the course of the Dotcom Bust (2000-02). However low vol, small worth, and dividend progress all climbed in the course of the crash. They hedged your losses at simply the suitable time.

Low volatility and dividend progress additionally suffered far lower than the S&P 500 in the course of the World Monetary Disaster and 2022’s inflationary surge. In the meantime, small worth enjoys a decrease correlation with the market than the opposite methods throughout your complete interval.

So there may be some strategic worth in considering past the uncooked returns, particularly in case your goal is to restrict drawdowns.

For instance:

• Wish to curtail your losses in a disaster? Contemplate low volatility and dividend progress.
• Wish to diversify your returns away from massive tech? Suppose small worth.

By the way, I discover the chance issue framework extra convincing than geography as a foundation for diversification. Maybe that’s one we are able to debate within the feedback?

Diversification potential

A correlation matrix may also help us assess the diversification advantages of every asset pair. The decrease the quantity the higher.

Small worth demonstrates probably the most diversification potential throughout the board. It’s the one technique that’s not extremely correlated with the broad market.

Much more intriguing is small worth’s comparatively low correlation with momentum and high quality. That signifies these are doubtless complementary property in case you’re occupied with a diversified multi-factor technique.

Dividend progress additionally has some diversification worth, so I’d additionally like to check how effectively it performs when paired with different methods…

Multi-factor mash-up

Let’s dial up the fortunes of three fairness portfolios:

• 50/50 momentum/small worth (SCV) – finest performer + most diversified
• 50/50 momentum/dividend progress – two sturdy performers + average diversification
• 50/50 dividend progress/small worth – simply to see!

Right here’s the returns for every portfolio ranged towards the market and their part methods:

The portfolios are rebalanced yearly.

What I’m in search of from my backtest portfolios is just a modest discount in long-term 25-year returns versus the strongest part.

I’d additionally prefer to see sturdy constructive diversification potential on the 25-year mark. That’s the perfect interval for getting a fast bead on the good thing about holding an in any other case weaker seeming asset.

I additionally need to verify if holding two imperfectly correlated property (for instance momentum and small worth) primarily delivers the market return. That’s, do they simply neutralise one another?

Not dangerous

The excellent news is that momentum and small worth don’t cancel one another out.

You continue to earn a 1% premium versus the market over the long-term, regardless of SCV’s poor exhibiting total.

The portfolio end result additionally considerably improves on the efficiency of the market and momentum over 25 years – the interval most affected by the background radiation of the Dotcom Bust.

Sure, you may rightly level out that small worth has proved to be a drag total. However you couldn’t have recognized that prematurely.

Furthermore, worldwide small worth has overwhelmed the worldwide market – even over the previous 5 years. And it’s lagged worldwide momentum by solely 0.5% annualised over these final 5 years, too.

In different phrases we are able to’t conclude small worth is lifeless (though it’s clearly resting within the US).

Dividend progress additionally proves out its diversification chops, whereas in any other case the numbers present what we already know – the technique delivered sturdy returns over 40 years.

Past that, I don’t suppose there’s any level me torturing the info to seek out some legendary candy spot involving, say, 17.37% of high quality and eye of newt and whatnot.

Basically, I simply wished to verify that selecting reasonably correlated components can produce a diversification uptick with out banjaxing the return premium.

For those who don’t need to put money into one thing that hasn’t outperformed for the final ten years then truthful sufficient. Stick with the market, I feel that’s a superbly rational place to be.

Present me the world

We will achieve an alternate perspective by checking dwell fund information. A raft of World threat issue ETFs launched in Europe in 2015, so we are able to nearly scrape up ten years value of GBP returns by evaluating them:

Nominal complete returns. ETF returns courtesy of justETF. 10-year return is definitely 9-years and 9-months as a result of youngest ETF’s inception date. Small worth is DFA’s World Focused Worth fund courtesy of Morningstar. Sharpe ratio is predicated on 10-year returns (not obtainable for small worth).

On this view, small worth is the perfect performer over 5 years however the second worst over ten.

Momentum is the one technique to beat the market convincingly over ten years.

Dividend progress had a very powerful time of it.

What does this inform us?

• It’s been a good time to be a momentum investor
• Don’t consider small worth is lifeless
• Don’t depend on any technique beating the market whilst you occur to carry it
• Don’t rely solely on return comparisons or the expertise of a single market to type a view

Personally, earlier than I commit a penny I need to learn impartial analysis that may supply:

• Some confidence the technique will work sooner or later
• A information to the dangers
• A cause to consider that is extra than simply an attention grabbing sample within the information or a conveniently organized backtest

Take it regular,

The Accumulator