The latest trend in investment strategies involves multi-factor investing. Investment managers attempt to add alpha by focusing on factors such as momentum, quality, market cap, growth and value. The most influential paper on momentum is arguably Mark Carhart’s 1997 study; adding momentum to the Fama-French Three Factor Model increased the model’s explanatory power and showed momentum was a key factor in describing cross-sectional returns.
Dimensional Fund Advisors (DFA) is a pioneer in employing academic research to implement quantifiable factors, such as size and value, to their investment process. While DFA believe the momentum factor is real, they have found no evidence it works in practice. Dimensional Fund Advisors studied U.S. momentum-style equity funds with at least three years of history and found that the majority of these portfolios weren’t able to deliver above-market returns for investors after fees.
Now, after years of research, DFA is adding a new factor based on the behavior of companies with high levels of investment. But Dimensional will be implementing this factor in its portfolios in a unique way, based on original research.
“We started looking at the relationship between investment and returns when we implemented the profitability component,” Savina Rizova, the firm’s head of research, said in an interview. “At Dimensional, we do want to vet research very thoroughly before implementing anything. We implemented the size factor in 1981 [when Dimensional was founded], value in the early ’90s, and profitability in 2012 to ’13.”
In the new paper, Rizova and co-author Namiko Saito looked into the behavior of stocks with high investment — as measured by asset growth — and whether it could be used to improve returns for investors. According to valuation theory, a well-known academic framework for analyzing financial data, a company that needs to pour money into research and development and other initiatives to sustain its profits — so-called “high investment” — should have lower cash flows than a company with similar profits that doesn’t need to invest as much to remain competitive.
The crucial finding in Dimensional’s new research was that the negative relationship between investment and average stock returns was really driven by the underperformance of small firms with high investment. The link was found to be weaker with large-cap firms.
In its investment process, Dimensional will quantify the investment factor using asset growth as its proxy. Rizova explained that firms can raise capital to invest with equity financing, debt financing, and retained earnings. Asset growth measures a combination of all three.
Based on its research, Dimensional will exclude small firms with high investment from its portfolios. At Triad Financial Advisors, we continue to lean on DFA’s academic findings to design what we believe to be the optimal risk/return portfolios for our clients.