Here's What's Really Driving Your Returns

Wall Street Journal / Joe Light and Ben Levisohn

The drama in Europe is putting the best-laid investing plans to the test. Each day, it seems, stocks are either soaring ("risk on") or plunging ("risk off")—yet for the year the Dow Jones Industrial Average has barely budged.

The main culprit: "correlation," or the extent to which assets move in unison, which reduces the benefits of diversification and limits investors' ability to control their portfolios. According to Birinyi Associates, the correlation between the stocks in the Standard & Poor's 500 and the index itself rose as high as 0.86 in October—nearly a perfect 1.0—from as low as 0.4 in February.

But don't despair. By changing the way you spread out your stock holdings, you can reduce risk and boost returns—even in a highly correlated market like today's.

The trick? A concept known as "factor investing," which originated in academia two decades ago and now is finding favor among institutional investors and high-end financial advisers.

Factor investing replaces traditional asset allocation—such as a portfolio with 30% in U.S. stocks, 20% in developed international markets, 10% in emerging markets and 40% in bonds—by focusing on specific attributes that researchers say drive returns. These "risk factors" include the familiar—like small versus large-size companies or growth versus value stocks—as well as more esoteric measures such as volatility, momentum, dividend yield, economic sensitivity and the health of a company's balance sheet.

Some studies have shown that certain factors in particular—such as exposure to small-capitalization and value stocks—give you more return for the amount of risk taken. Other studies have shown that factors have had low historic correlations with one another, making the factor approach increasingly attractive to big institutions looking for true diversification.

Until recently, it was hard for small investors to dabble in factor investing. But that is changing.

In the past year at least six firms - BlackRock's iShares, Russell Investments, Invesco PowerShares, Factor Advisors, QuantShares and State Street Global Advisors - have launched factor-based exchange-traded funds, or have filed paperwork to do so.

Sean Crawford, a portfolio manager at Barclays Wealth who also helps vet new products for the firm, recommends holding off on investing in one of these ETFs until they accumulate at least $100 million in assets and have at least three months of trading history, in order to see how they behave and how well they track the underlying index.

But even if the products aren't quite ready for prime time, investors can use factor investing to their advantage, says Jason Hsu, chief investment officer for money manager Research Affiliates.

What's a Factor?

Factor investing has its roots in academic research from the 1960s. The "capital asset pricing model" identified one factor, beta, or a stock's volatility relative to the index, as pivotal to the stock's returns. The model quickly became a cornerstone of investing theory, and it helped earn William Sharpe and Harry Markowitz the Nobel Memorial Prize in Economic Science in 1990.

In the 1990s, professors Eugene Fama of the University of Chicago and Kenneth French of Dartmouth College's Tuck School of Business found that size (large versus small) and style (growth versus value) also helped explain a stock's returns—and showed that smaller stocks and value stocks that trade at low price/book ratios tend to perform best over time. Their three-factor model is one of the most popular among researchers, though many now include momentum as a fourth factor.

Other studies have identified factors that are less agreed upon, such as a stock's volatility and its sensitivity to gross domestic product. Axioma, a firm that provides risk models and portfolio-construction tools for stock investors, uses 10 factors for U.S. stocks, including exchange-rate sensitivity, debt load and momentum, or the tendency of a rallying stock to keep rallying. MSCI's Barra, a competing firm, uses 12 factors.

Big investors are taking heed. In 2009, researchers assigned to analyze the Norwegian Government Pension Fund recommended it reorient its portfolio around risk factors. And the California Public Employees' Retirement System underwent a similar change in approach in 2010. Other big institutions, such as part of the government pension fund for Sweden, also are exploring how to balance risk factors.

"Pre-Lehman, the focus was on asset allocation" and a diversified approach to active management, says London Business School professor Elroy Dimson, who is also head of the Strategy Council for the Norway fund. "During the post-Lehman meltdown, Norwegians had factor exposures that they didn't know they had."

Ordinary people are factor investors, too—whether or not they realize it. Morningstar 's famous style box, for instance, reflects the two best-known factors: style and size. For example, if you keep your entire stock portfolio in the iShares S&P 500 Index Fund ETF, you basically own large-cap stocks with no strong bias toward value or growth. If you own the SPDR S&P Dividend ETF, on the other hand, you have large-cap value stocks (though not as large, on average, as those in the S&P 500 ETF).

Recent research has shown that more exposure to additional factors can juice returns.

"There are a lot of nuances you may be missing by focusing only on style and size," says Savita Subramanian, head of equity and quantitative strategy at BofA Merrill Lynch Global Research. "You may be missing a whole layer of outperformance you could have gotten."

For instance, for investors looking for stability, the traditional choice might be a large-cap value fund. But large-cap value has performed terribly this year: The SPDR S&P 500 Value ETF has dropped 4.5%, more than six percentage points below the S&P 500's return.

Adding a low-volatility tilt could have improved performance, since low-volatility stocks tend to hold up better during market routs. The PowerShares S&P 500 Low Volatility ETF, for example, is weighted toward large-cap value stocks, according to Morningstar, but its low-beta characteristics helped boost performance during recent downswings. The ETF gained 0.1% in August, for example, 6.4 percentage points better than SPDR S&P 500 Value.

How to Use Factors

The first step is to understand your current factor exposure, starting with three factors that most researchers agree on: beta, size and style. Any financial adviser should be able to do a factor analysis for you.

If you are on your own, a good place to start is Look up your current holdings and check out the style map, which shows your size and style weightings. If a dot appears toward the upper-right-hand part of the map, for example, it means your portfolio is tilted toward large, growth stocks.

Under the "Ratings & Risk" tab, you can find the fund's three-year beta. A beta of 1 means the fund moves in tandem with the index. If beta is higher than 1, it is more volatile than the index.

Morningstar's style box and risk ratings won't give you as exact a picture of your exposure to each factor as a financial planner's analysis would, but it will help you understand the overall tilts of your portfolio.

Once you see which factors you tilt toward, see if you can find ETFs to duplicate your exposure at a lower cost, says Christopher Van Slyke, a financial planner in Austin, Texas. There are several low-cost small-cap, large-cap, growth and value ETFs to choose from, including those from Vanguard Group, iShares and, if you use a financial planner, Dimensional Fund Advisors.

For example, if you previously have devoted most of your portfolio to broad index funds, you might find that your investments tilt slightly toward growth stocks and heavily toward large-cap stocks. Yet the research by Profs. Fama and French shows that small-cap stocks and value stocks tend to do the best over time.

Instead of putting your entire portfolio in the Vanguard Total Stock Market ETF, for example, you could put 75% in the total-market ETF and 25% in a small-cap-value ETF like Vanguard Small-Cap Value or PowerShares Fundamental Pure Small Value Portfolio . The FlexShares Morningstar U.S. Market Factors Tilt ETF, which launched in September, places the strategy in one package.

Be warned: Small-cap and value stocks can go through long periods of underperformance, and investors must resist the urge to chase returns.

"If you're going to tilt your portfolio to small-cap value, you have to be willing to stick with it," says Rick Ferri, founder of Portfolio Solutions, an investment adviser in Troy, Mich.

Since small value stocks have a higher expected return, investors can increase their allocation to bonds to reduce volatility, says William Bernstein, an investment manager at Efficient Frontier Advisors in Eastford, Conn. Those who had 60% of their portfolios in stocks and 40% in bonds in a market-cap weighted portfolio can put just 50% of their money in stocks in a small-cap value-weighted portfolio, he says.

By design, your new portfolio will no longer simply track a market-cap weighted benchmark, such as the MSCI All-Country World index. So you will have to have the fortitude to stick with the plan when there are times you lag behind broad index funds.

Trading Vehicles

Factor ETFs are particularly suited to short-term bets, says Ms. Subramanian of Bank of America Merrill Lynch. That is because they provide a simple way for investors to add exposure to a particular area without making wholesale changes to their portfolio.

"One way to effectively use them may be as satellite bets on your overall core strategy," she says.

Take an investor with a portfolio of high-quality dividend stocks, like the SPDR S&P Dividend ETF. During tough times, the ETF will typically outperform the overall market. In 2011, for example, it has gained 4.2% without even counting dividends, versus the 2% gain of the S&P 500 including dividends. That investor, however, faces a predicament if the market rallies, since dividend stocks typically trail during market surges. In 2009, for example, the dividend ETF gained 19%, 7.4 percentage points less than the S&P 500.

Rather than selling all the dividend payers, the investor could sell a portion of the portfolio and use the proceeds to buy a high-beta ETF, which should, in theory, perform better if the market rallies. During October, for instance, the PowerShares S&P 500 High Beta ETF gained 19%, nearly double the S&P 500's 10.9%.

The same holds true for other factors like momentum and quality.

"If you're heading into a market where you think high beta will outperform, you can use an ETF to tilt toward beta," Ms. Subramanian says. "It's a happy medium between indexing and active management."