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Beating the Market with Fama and French 3 Factor Model? Small-Cap and Value Factor ETFs Combined! - YouTube
Channel: fu academy
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How nice would it be to have a portfolio
that can consistently beat the market.
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Well, there is actually a Nobel
prize winning strategy out there:
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The Fama and French 3 Factor Model.
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Ever heard of it?
Me neither!
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That's why we will break it down in this video.
We will go through the model quickly and
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look at how you can build that
portfolio yourself - let’s go!
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What’s up everyone?
This is fu
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academy - your channel for financial education.
And on this channel, I share lifestyle, investing
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style and educational videos - just like this one.
So if you are new here, consider subscribing.
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The Fama French Model was invented by Nobel prize
winner Eugene Fama and Kenneth French in 1992.
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Their model is based on the capital asset pricing
model and whoever has done a company valuation
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before might have seen this.
Don’t worry if not.
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The capital asset pricing model measures the
expected market return of the stock market
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in excess of risk-free investments
like the return you would get on a US
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10-year treasury rate which currently is 1.74%.
So it’s essentially the risk premium that you
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get for investing your money in riskier
investments than just treasury bonds.
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And without getting too technical here, Fama and
French’s model builds upon this first factor,
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the expected market return, by
adding the 2 additional factors:
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Value and Small-Cap.
But why?
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They tested thousands of random stock portfolios
and found out 2 things in their research.
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Number 1: Value stocks tend
to outperform growth stocks.
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And number 2: Small-Cap stocks tend
to outperform Large-Cap stocks.
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Fama and French came to the conclusion that
when you combine Value and Small-Cap with the
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expected market return, then this explains 95%
of the return in a diversified stock portfolio.
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So in total, Fama and
French's model has 3 factors.
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If you are looking to build a
portfolio with these 3 factors,
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you could use the Core-Satellite strategy.
The core is the centre of that portfolio that
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passively tracks the market - and that’s
where the majority of your money goes.
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The satellites are used for bets on
specific industries or investment styles
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that have the potential to produce
a higher return than the market.
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If we go back to Fama and French's 3
factor model, then the first factor
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is the expected market return.
This can be the core of your portfolio
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in which you invest the majority of your money.
For this, you could use a low-cost plain ETF
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that just tracks the market like Vanguard's
Total Stock Market ETF which tracks the US
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stock market or Vanguard's Total World Stock
ETF which tracks the global stock market.
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If you want to find out which of
these 2 core ETFs is best for you,
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then check out the video in the link.
What we will focus on in this video
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are the 2 satellite investments: One for the
Small-Cap factor and one for the Value factor.
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By the way, if you want to learn more about the
Core-Satellite strategy and how to set it up
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yourself, then check out the video in the link.
So let’s have a look at investment options
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for Fama and French's second factor: Size.
For this one, you could use the iShares Core
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S&P Small-Cap ETF, ticker symbol IJR.
It’s one of the oldest, biggest,
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simplest and cheapest ETFs out there.
This ETF tracks the S&P SmallCap 600 Index.
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This index only includes US companies
with a market cap between $750m to $3.3bn,
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that have a public float of at least 10% and
its most recent quarter’s earnings and the sum
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of its trailing four consecutive
quarters’ earnings must be positive.
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The IJR has an expense ratio of 0.06% - making
it one of the cheapest Small-Cap ETFs out there.
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Its performance in the last 10 years was
strong with an annual return of over 14%,
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only 2% less per year than the S&P 500.
This ETF has a fund size of $69bn which
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makes it the largest Small-Cap ETF out there.
This ETF invests in over 600 companies.
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If we have a look at the top holdings, you
will see companies like Omnicell, for example.
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But compared to an S&P 500 ETF, the top
holdings are definitely less well-known.
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But that’s also what you
expect from a Small-Cap ETF.
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The top 10 holdings make up less than 5% of
the fund - which is incredibly well-balanced.
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If we have a look at the sector breakdown,
you will see that this ETF mainly invests in
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Financials with an exposure of 19%.
Tech only comes in at number
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3 with an exposure of 13%.
This ETF only invests in US stocks.
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And dividends are paid out quarterly
with a dividend yield of 1.65%.
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Now the IJR is a good starting point
when you look at Small-Cap ETFs.
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But it’s not the only interesting option.
There is also the iShares MSCI EAFE Small-Cap ETF,
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ticker symbol SCZ.
And the special
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feature of this ETF is its global focus.
This ETF invests in over 2,300 companies
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from 21 countries - so mega diversified.
And for the investors that want to go green,
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there is the iShares ESG Aware MSCI
USA Small-Cap ETF, ticker symbol ESML.
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If you want to know more about ESG investing,
then check out my dedicated ESG video in the link.
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For investors outside the US, I put
together UCITS alternatives which
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you can find in the video description below.
By the way: If you want to see my dedicated
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video in which I review the best Small-Cap
ETFs, then check out the video in the link.
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Now let’s check out Fama and
French's third factor: Value.
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And that brings us to Vanguard’s
Value ETF, ticker symbol VTV.
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It’s one of the largest and
cheapest Value ETF out there.
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This ETF tracks the CRSP US Large Cap Value Index
which selects companies based on Value metrics
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like Price-to-Book, forward P/E, historic
P/E, Price-to-Dividend and Price-to-Sales.
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The VTV has a dirt-cheap expense ratio of 0.04%.
Its performance over the last 10 years was solid
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with an annual return of 13.2%, which
was 3% lower than the S&P 500 return
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over the same time frame - per year.
And if you look at the performance chart,
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you can also see where that difference comes from.
Until the 2020 crash, the VTV and the S&P 500
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index had an almost identical performance.
But since the 2020 crash,
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the VTV recovered slower.
And that’s because the S&P
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500 index is dominated by Big Tech - and it’s
tech companies that benefited the most from a
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shift towards ecommerce and cloud technology.
This ETF has a fund size of $94bn which makes it
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not just the largest Value ETF out
there but also puts it in the top
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10 of the largest ETFs - period.
The VTV invests in 351 companies
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which gives you a nice diversification.
In the top 10 holdings, you will find
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well-known companies like Berkshire of course,
and banks like JP Morgan and Bank of America.
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The top 10 holdings make up 20% of the fund -
which is a relatively high concentration risk.
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Important to note: The VTV
only invests in US companies.
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If we have a look at the industry
breakdown of this ETF, you can see
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that the industries with the highest exposure
are Financials, Health Care and Industrials.
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These 3 industries alone make up 54%, whilst
the exposure to Tech companies is only 7%.
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And that’s the opposite of the S&P 500 industry
breakdown but quite common for Value ETFs.
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If you think about it, it makes perfect sense:
Tech companies are usually high-growth companies
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with a lot of future potential.
And for all that, investors are
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willing to pay a higher price today,
which pushes up their valuations.
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Banks, on the other side,
don’t grow massively anymore.
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They are more stable and established companies
that meet a lot of criteria for Value investors.
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And they tend to be cheaper because they don’t
create as much excitement amongst investors.
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And lastly, the VTV pays out dividends
every quarter with a dividend yield is 2.2%.
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This ETF is a great place to
start looking for a Value ETF.
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It gives you easy and diversified exposure
to Value stocks at a very fair price.
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But it’s not the only interesting option.
There is also the iShares MSCI International
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Value Factor ETF, ticker symbol IVLU.
This one is a global Value option.
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This ETF invests in 19 developed countries.
And for investors that want to go green,
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there is the Nuveen ESG Large-Cap
Value ETF, ticker symbol NULV.
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I also put together UCITS alternatives for
investors outside the US which you can find
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in the video description below.
By the way: If you want to see my
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dedicated video in which I review the best Value
ETFs, then check out the video in the link.
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But to be fully transparent: I personally
don’t own Value ETFs as my satellites.
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And that has a reason.
Most Value ETFs filter
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out companies with a high Price-to-Book ratio.
And a company these days can activate pretty much
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everything: Software, furniture and so on.
Activating assets will increase your book value.
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But the network effect of platforms
like Meta is something that you
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won’t find on the balance sheet.
That happens outside the balance sheet.
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But that’s also where the value
of these companies really sits.
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That’s something Value ETFs can’t capture.
There you have it: The Fama and French 3 Factor
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Model explained and how to set it up yourself.
One big downside of this model is
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that it was built in 1992.
And back then, yes Value and
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Small-Cap outperformed the total stock market.
But since then, the opposite has happened.
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Growth and Large-Cap kept outperforming.
And today, the S&P 500 is dominated by Big Tech,
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so growth stocks.
So much so that the
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5 largest companies of the S&P 500 are all tech
companies and they hold the highest share the top
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5 companies have ever held - almost 20%.
So this model isn’t perfect.
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But it’s a good way to think
about portfolio construction.
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But hey - what do you actually think
about the Fama and French model?
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Is it still applicable in today’s
environment or is it outdated?
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Are you investing in Value
or Small-Cap ETFs already?
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As always - let me know in
the comment section below.
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I hope that this video could
bring some value to you.
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If you liked what you saw and you want to support
this channel, then please make sure you subscribe.
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Thank you very much for doing that - and peace!
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