Everyone, Even a Passive Vanguard Investor, is a Factor Investor

////Everyone, Even a Passive Vanguard Investor, is a Factor Investor

Everyone, Even a Passive Vanguard Investor, is a Factor Investor

By | 2017-11-30T10:36:35+00:00 November 30th, 2017|Factor Investing, Research Insights|5 Comments

Much has been made of Factor Investing, and even Vanguard is launching a suite of actively-managed factor ETFs. But even now, with Vanguard offering factor ETFs, there are many investors that only invest passively into an index fund, such as the SP500 or EAFE index. These investors will cite the numerous studies showing that (on average) active management fails compared to an index fund (there are many studies that highlight this fact).

No arguments with most of those studies and costs clearly matter, but what I would like to highlight in this article is the following:

Even passive index investors are betting on factors.

The idea behind this article is to highlight/review a summary of the literature on factors. Many tend to forget, but the factor with the largest premium is the market factor!(1) Yes, simply investing in the market (i.e. the Sp500) is not really passive — this is a factor-investing bet. Investors in the market-beta asset class are implicitly betting on the equity-premium, which is the outsized returns (in the past) to equities over U.S. Treasury Bills (or cash).(2)

Let’s dig into a few papers that are relevant to this topic.

Factor Returns

The term “factor investing” has come to mean the following to most investors–sorting stocks and bonds on some favorable characteristic(s) that will create a different performance profile than a passive index portfolio. “Smart-beta” funds that sort stocks based on value or momentum are a classic example.(3) Factor investing exists in bonds as well, but is just not discussed as much.

And why do people invest in factors?

Typically, factors are identified when a researcher finds that going long the “good” stocks and selling the “bad” stocks earns a positive risk-adjusted premium. These so-called L/S anomaly portfolios generally have no market beta (at least on a $ amount), and receive a positive return (minus the risk-free rate) from the long/short stock portfolio.(4)

Below are the compound annual growth rates (and standard deviations) to the long/short factor portfolios from Ken French’s website and AQR’s website (for the QMJ and BAB factors). All returns are gross of any transaction costs or management fees, which would decrease the returns. Returns are from 7/1/1963 – 12/31/2016.

CAGR 2.19% 4.07% 7.08% 2.73% 3.55% 4.08% 9.62%
Standard Deviation 10.69% 9.77% 14.64% 7.32% 6.85% 8.27% 11.07%
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

The factors are the Size factor (SMB), the Value factor (HML), the Momentum factor (MOM), the Profitability factor (RMW), the Investment Factor (CMA), the Quality factor (QMJ) and the Low-Volatility or Beta factor (BAB). References to these factors can be found in the appendix.(5)This post is not designed to be a deep dive into factors, but the results above show that (on paper before any trading costs and management fees), there was a positive return associated with these factors, which has generated an explosion of equity factor-investing options.(6)

But what about an investor in the stock market who simply uses the passive Vanguard Sp500 fund?

That person cannot be considered a factor investor, can they?

Turns out these investors are betting on an obvious factor–the market factor.

The Market Factor

So what is the market factor? The market factor has also been described as the “equity premium puzzle” in the past. The market factor was deemed a puzzle to economists, because they were unable to come up with a model that allowed for expected stock returns to be so high relative to the returns to Treasury Bills (cash-equivalent) returns. The original paper on this topic was “The equity premium: A puzzle” by Mehra and Prescott (1985) (post on the subject here).

A nice summary of the premium puzzle can be found here, by Rajnish Mehra (2003). From that summary, there is a nice image indicating how large the returns to equity has been relative to cash, both over different time periods in the U.S. as well as for international markets:

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Note that the returns above are “real,” meaning that inflation has been deducted from the returns. As everyone can see above, there was a higher return to equities relative to cash both (1) in different time periods in the U.S. and (2) in international markets. Many papers have been written since then to attempt to explain “why” this occurs. One example found here by Benartzi and Thaler (1995), is that investors are (1) loss averse and (2) assess their portfolios often–this causes what the author’s title “myopic loss aversion.”

In general, the explanation is the following–equities are more volatile, and investors do not like volatility (who likes to potentially lose $?).

Below is the equity premium, per year and over a 20-year cycle, in the Mehra (2003) paper:

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

What one notices is that from year to year, the equity-risk premium is generally positive, but has a lot of negative years. However, over a 20-year cycle, the premium has always been positive (in the past). And this is the offering Vanguard gives to most investors–the market factor.


Vanguard is moving into “factors,” but they have always been a factor investing shop–their main factor is the market factor.

And to be clear, the market factor is a reasonable factor if one has the capacity to bear (and hold onto) risk.

We would also argue (surprisingly, along with Vanguard!) that adding other factors, such as value, momentum, and trend can possibly help a portfolio capture alternative return premiums.(7)

So in the end, everyone, even a passive Sp500 Vanguard investor, is a factor investor. They are betting on generic market risk.

Hopefully, that market factor will continue to work in the future, but like all factors that expect to earn a positive premium over time, one should expect a rocky road at some point in the future!

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References   [ + ]

1. Although MOM and BAB factors may give the market factor a run for its money (on paper)
2. Note that I focus this article on stock investing, but the same can be said about bond investing. Even passive Vanguard Bond investors are factor investors–they are investing (possibly without knowing it) in the duration/maturity factor, whereby investors generally receive a higher coupon/yield for lending money for a longer period of time. Invest in corporate or high-yield bonds through a passive Vanguard mutual fund? You are betting on the credit/default factor, whereby investors (in the past) received a higher coupon/yield on their investment for investing in lower quality debt (relative to the riskless asset–U.S. government debt). For information on these simple papers, one can review the Fama and French 1993 paper, found here.
3. Some other factors are quality, profitability, low volatility to name a few
4. This is anomalous, based on the CAPM framework, which is described in this equation: R_i = R_f + \beta_i(R_m - R_f). Since the beta of the portfolio is generally ~ 0, the returns to the portfolio (R_i) should be equal to the risk-free rate (R_f). However, when running the regressions, one notices an abnormal return, hence the anomalous factor.
5. The paper on the SMB, HML, RMW, and CMA factors, the paper on the MOM factor, the paper on the QMJ factor, and the paper on the BAB factor
6. It should be noted that these are the returns to long/short portfolios, while most smart-beta funds are long-only.
7. We are big fans of trend-following, so we have a dynamic exposure to the market-factor exposure when the equity trend is positive, described here.

About the Author:

Jack Vogel

Jack Vogel, Ph.D., conducts research in empirical asset pricing and behavioral finance, and is a co-author of DIY FINANCIAL ADVISOR: A Simple Solution to Build and Protect Your Wealth. His dissertation investigates how behavioral biases affect the value anomaly. His academic background includes experience as an instructor and research assistant at Drexel University in both the Finance and Mathematics departments, as well as a Finance instructor at Villanova University. Dr. Vogel is currently a Managing Member of Alpha Architect, LLC, an SEC-Registered Investment Advisor, where he heads the research department and serves as the Chief Financial Officer. He has a PhD in Finance and a MS in Mathematics from Drexel University, and graduated summa cum laude with a BS in Mathematics and Education from The University of Scranton.


  1. David Foulke
    David Foulke November 30, 2017 at 10:29 pm

    Jack, I have a question. Cliff Asness was commenting on studies that used active fund data to assess implementation costs. He said, “Some…aren’t studies of direct factor implementation but inferences from actively managed funds. Not sure that works. What would they say about the feasibility of the market factor?” I’m not sure I follow. Is he saying that the frictional/implementation costs from mutual funds are so high that they erode the entire market factor?

    • Wes Gray December 1, 2017 at 8:11 am

      Hey David,
      Using the technique they outline (fama macbeth) they find that managers earn ~50% of the market risk premia. But one of the points of the post is that the technique deployed sucks (technical term). I think a better approach is via actual transaction data where we already know the cost of catching market beta — 5-10bps

  2. Jack Vogel
    Jack Vogel December 1, 2017 at 9:31 am

    Hey David — There are some new studies that attempt to “infer” trading costs by running 2-stage regressions. While a neat new idea, I point out in the link below that there are confounding issues when attempting to infer trading costs, such as (1) statistical issues, (2) closet-indexing, and (3) factor switching to name a few. The AQR paper directly tests the trading costs, using their data on trades (over a trillion dollars of trades), so that is what he means by a direct test, as opposed to inferred. I hope that helps!



    Here is my best guess as to what he means about the market factor. If someone says (in a paper/study) that they have determined trading costs or capacity constraints have eliminated a factor premium, then a natural corollary should be that they should know when the market premium will be zero; yet no one discusses that issue.

  3. Skot Kortje
    Skot Kortje December 1, 2017 at 10:24 am

    Absolutely appreciate this article. Thank you. However, just wondering why a market fund like Vanguard SP500 cannot be simply categorized as a size factor? I understand the market factor category as helpful in quantifying the equity premium but isn’t the construction of market cap indexes by definition a size factor and as such most passive investors are, at a minimum, exposed to a size factor? My apologies if I’ve misunderstood the category.

    • Wes Gray December 1, 2017 at 4:57 pm

      Yes. The S&P 500 is arguably long market factor and short size factor. Definitely.

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