Five Factor Investing with ETFs (EP.129)

Episode Summary

Executive Summary: Episode 129 centers on Rational Reminder’s new model ETF portfolio and the research behind it. The hosts review factor investing theory, explain why markets are broadly efficient yet factor premia persist, compare value-weighted vs academic factor returns, and justify a new six-ETF Canadian-implementable portfolio tilted to small-cap value. They also touch on ETF industry growth, estate planning, Peloton/community updates, and a bad-advice example about region-picking international ETFs.

Main Topics: New model ETF portfolio launch: The episode introduces a revised portfolio design intended to mirror the firm’s client implementation while remaining accessible to listeners, emphasizing practical Canadian ETF choices and factor exposure. Factor investing and asset pricing theory: A long explanation of efficient markets, alpha, CAPM, and the Fama-French models, showing how systematic risk factors can explain return differences and inform portfolio construction. Evidence on factor premia and diversification: The hosts review historical premiums for size, value, profitability, and investment across U.S., developed, and emerging markets, plus rolling-period persistence and low correlations across factors. Implementation trade-offs in ETFs: They discuss why the portfolio uses Avantis and Canadian-listed funds, the costs and tax frictions of U.S.-listed ETFs, and the decision to prefer VUN over XUU due to tracking concerns. Practical investing lessons and critique of bad advice: The episode closes by criticizing region-picking and near-term forecasting in international equity ETFs, reinforcing globally diversified, evidence-based factor investing instead. Miscellaneous community and market news: Short segments cover the Rational Reminder community, Peloton hashtag, a Netflix recommendation, ETF industry growth, and the importance of wills after Tony Hsieh’s death.

Key Arguments: Market efficiency implies you cannot reliably earn excess returns without taking more risk; persistent outperformance should be understood in a risk-factor framework. The Fama-French five-factor model provides a stronger and more theoretically grounded explanation of returns than CAPM or the three-factor model. Factor premia are economically meaningful and often statistically significant across major markets, making them hard to ignore in portfolio construction. Academic factor portfolios are overweight small caps, so raw factor premium estimates can overstate what an ordinary investor would capture; implementation matters. Small-cap value and related tilts can improve expected return and diversification, but they must be balanced against costs, taxes, and simplicity. Dividend growth portfolios often look attractive but may simply package exposure to profitability and conservative investment rather than deliver unique alpha. International diversification remains valuable, but choosing regions based on near-term views is not supported by evidence. The new model portfolio aims to capture factor premia more directly while staying implementable for Canadian investors through low-cost ETFs.

Data Points: Podcast episode: 129 - The feature episode number introduced by the hosts. Community size: Nearly 1,000 users - The Rational Reminder community board was approaching a thousand members. Naval Ravikant book availability: Free PDF download - The Almanack of Naval Ravikant can be downloaded for free at navalmanack.com. SP 500 stocks with dividend yield above 10-year Treasury yield: 63% - Mentioned as the highest level in a table going back to 1990. Average share of S&P 500 stocks above 10-year Treasury yield: Just under 20% - Historical average for the same dividend-yield comparison. ETF issuers launched in 2020: 14 - Compared with 10 new issuers in 2019. ETF industry assets: $5.2 trillion - Referenced in a Bloomberg article on new ETF issuers. November ETF inflows: $90 billion - Record monthly ETF inflows cited during the discussion. Year-to-date ETF flows: $427 billion - Flows were about $35 billion shy of an annual record. BlackRock ETF assets: $1.8 trillion - Largest ETF provider cited in the industry update. Vanguard ETF assets: $1.1 trillion - Second-largest ETF provider cited. State Street ETF assets: $700 billion - Third-largest ETF provider cited. Dimensional U.S. Core Equity Index return: 13.52% - 1975 to June 2020, compared with the U.S. market index. U.S. total market index return: 12.12% - 1975 to June 2020 comparison benchmark. Dimensional U.S. Core Equity Index standard deviation: 15.43 - Used in the comparison showing higher return with similar risk. U.S. total market index standard deviation: 15.41 - Benchmark risk level in the same comparison. Value-weighted small-minus-big premium: 1.58% - U.S. factor premium from 1963 to June 2020. Value-weighted value premium: 1.99% - Cheap stocks minus expensive stocks, U.S. value-weighted series. Value-weighted profitability premium: 2.59% - High profitability minus low profitability, U.S. value-weighted series. Value-weighted investment premium: 1.92% - Conservative minus aggressive investment, U.S. value-weighted series. Academic small premium: 2.04% - U.S. academic factor return using 50/50 small-large weighting. Academic value premium: 2.68% - U.S. academic factor return with small and large stock weighting. Academic profitability premium: 2.8% - U.S. academic factor return. Academic investment premium: 2.93% - U.S. academic factor return. Developed ex-U.S. value premium: 3.01% - Academic factor returns referenced for developed international markets. Developed ex-U.S. profitability premium: 4.30% - Academic factor returns referenced for developed international markets. Developed ex-U.S. conservative investment premium: 1.34% - Academic factor returns referenced for developed international markets. Rolling 10-year U.S. market premium positive frequency: 80% - Share of overlapping 10-year periods with positive market premium since 1963. Rolling 10-year small-cap premium positive frequency: 71.5% - Frequency of positive small-minus-big returns over overlapping 10-year periods. Rolling 10-year value premium positive frequency: 86% - Frequency of positive value-minus-growth returns over overlapping 10-year periods. Rolling 10-year profitability premium positive frequency: 85.6% - Frequency of positive profitability premium over overlapping 10-year periods. Rolling 10-year investment premium positive frequency: 98% - Frequency of positive conservative-minus-aggressive premium over overlapping 10-year periods. Negative U.S. market 10-year periods examined: 111 - Periods from July 1973 to June 2020 where the market premium was negative. Periods where SMB, HML, and CMA were all positive during negative market periods: 111 of 111 - All negative-market 10-year periods also had positive small, value, and investment premia. Japan market return: 2.36% annualized - July 1990 to December 2019, below U.S. T-bills. Japan one-month U.S. Treasury bill return: 2.63% annualized - Benchmark over the same Japan comparison period. Japan small-cap value return: 5.43% annualized - Dimensional Japan Small Cap Value Index, July 1990 to December 2019. Japan value index return: 7.96% annualized - Fama-French Japan Value Index over July 1990 to December 2019. Model portfolio equity holdings: 6 ETFs - The new model portfolio uses six ETFs for the equity sleeve. U.S. equity allocation: 30% VUN - Canadian-listed U.S. market exposure, replacing XUU due to tracking concerns. Canadian equity allocation: 30% XIC - Home-biased Canadian equity exposure. U.S. small-cap value allocation: 10% AVUV - Factor tilt toward U.S. small-cap value. International core equity allocation: 16% XEF - Developed international exposure. International small-cap value allocation: 6% AVDV - Factor tilt toward international small-cap value. Emerging markets allocation: 8% XEC - Emerging markets exposure. Factor-tilted portfolio fee: ~14 bps - Approximate total management fees for the factor-tilted model. Cap-weighted benchmark fee: ~11 bps - Approximate fee level for the benchmark comparison portfolio. 20-year factor-tilted portfolio return: 5.78% - Historical illustration for the tilted model. 20-year benchmark return: 4.96% - Historical illustration for the comparable cap-weighted benchmark. $10,000 ending value with factor tilt: $30,800 - 20-year illustration of growth under the tilted model. $10,000 ending value benchmark: $26,300 - 20-year illustration of growth under the benchmark. VIG period analyzed: June 2006 to June 2020 - Dividend growth ETF comparison to the U.S. market. VIG alpha: -0.48% annualized - Economically negative but statistically insignificant over the sample. VIG model fit: 94.8% - Share of monthly return variation explained by the Fama-French five-factor model.

Pivotal Quotes: "In any situation in life, you always have three options: you can change it, you can accept it, or you can leave it." — Benjamin Felix: Quoted from the Almanack of Naval Ravikant discussion as a memorable life principle. "If the market is efficient, then prices ... contain information about the expected returns of a security at a point in time." — Benjamin Felix: Used to explain why prices and expected returns are linked in efficient markets. "Why would you ignore information that's out there to be had?" — Cameron Passmore: Used to justify considering factor evidence in portfolio construction rather than relying on plain market beta.

Implications: Listeners get a concrete, lower-cost factor-tilted portfolio framework and a reminder that evidence-based investing is about improving expected outcomes, not forecasting winners. The episode also reinforces that implementation, taxes, and diversification matter as much as theory.