Deep Dive: Endowus Factor Portfolios by Dimensional

About the Endowus Factor Portfolios

The factor-based investing style aims to pry better returns from securities that outperform their peers, or that are more defensive amid market turmoil. The Endowus Factor Portfolios are designed for investors who want risk-adjusted performance gleaned from harvesting premiums systematically, and according to proven factors that have endured the test of time. 

The portfolios gain diversified exposure to long-term drivers of higher expected returns, such as value, size, and profitability in equities; and term and credit in fixed income, through systematic funds managed by Dimensional. Diversification is critical to long-term risk-adjusted returns and investor success. These portfolios are globally diversified across more than 10,000 stocks in 43 markets, and over  890 government and corporate fixed-income instruments.

The new Factor Portfolios by Dimensional are managed in a discretionary manner by the Endowus Investment Office. Endowus does not make any tactical changes to the asset allocation or active discretionary trading. It maintains the core strategic, passive asset allocation framework for portfolio design that Endowus espouses. However, the discretionary management means investors can rely on Endowus’ expertise to monitor, automatically rebalance, and optimise the asset allocation so that the portfolios deliver the highest risk-adjusted returns for the intended goals and the appropriate risk suitable for our clients. 

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Factor investing explained

At the heart of factor investing is a question for the ages: why do certain stocks and bonds rise or fall more than the rest? It is a question so deceptively simple, but has spurred on decades of research to uncover some factors that drive better performance. 

Dr Eugene Fama and Ken French discovered in 1992 three factors that explain over 90% of the stock return — those are market returns (we call market beta), size (smaller companies tend to outperform larger companies) and value (cheaper companies tend to outperform more expensive companies). This marked the beginning of factor investing. 

Fast forward to today, the endeavour of factor discovery is still ongoing, and there is an expanded set of factors. For stocks, these have expanded into factors such as quality, momentum, and minimum volatility. In the fixed income space, these factors include term and credit. To qualify as an investment factor, the factor needs to be persistent across time, and prevalent in different markets. Usually, there is a risk-based or behaviour-based explanation to why securities defined by certain characteristics tend to outperform in the long term. 

This is why people like to say factor-based investing is evidence-based. It is based on empirical evidence by studying decades of observations in multiple markets, and is fundamentally supported by economic rationales. So while the pursuit of alpha (return above market performance) is exhilarating,  partly because no one knows for sure how that alpha is generated, an investment strategy seeking to gain exposure to the market and proven factors of return such as value, size and quality is more assuring to many investors.

Long-term factors used by Dimensional Fund Advisors

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Dimensional summarised the essence of systematic factor investing very well: “Systematic (factor) investing typically seeks to outperform markets by structuring investments around factors linked to differences in expected returns. This differentiates systematic investing from traditional indexing, which typically seeks to deliver market returns, and traditional active investing, which may seek outperformance by identifying so-called mispriced securities or timing markets.”

‍How has factor investing performed?

In the equities market, over the long term, the statistical evidence for outperformance of small, cheaper and higher quality companies compared with their respective counterparts is overwhelmingly positive in US, developed ex-US and emerging equity markets. This is illustrated in the chart below.

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In the fixed income market, the charts below indicate higher average term and credit premiums during months when term and credit spreads are wider. There is a body of academic research that provides support for the reliable relationship between the width of credit and term spread, and the subsequent premiums.

However, those familiar with the value-investment style in equities would know that the past decade from 2010 to 2020 marked a lost decade for the value factor. It was a golden decade for growth stocks: the US was the best performing market and within the US, the blue-chip firms that offered high growth at rich valuations performed the best. The value factor’s underperformance against the growth factor was observed not only in the US but also in the rest of the world. It was a soul-searching decade for value investors, and many were asking the question whether value is gone.

Is Value coming back? 

There has been ongoing debate in the market on whether the persistent low interest rate environment may have been the culprit for the underperformance of the value factor in the past decade. While there remains no conclusive evidence, those who argued that way may be right. As the Fed turned increasingly hawkish in 2021, the value factor made a strong comeback. This has continued into 2022. While the overall equity market has been down, growth stocks have led the losses, with value stocks holding up relatively well.

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The investment strategies managed by Dimensional struggled to stay above benchmark performances during extended periods during the past decade due to the tilts to the value factor. The strategies’ tilts to size and profitability helped to offset some of the underperformance but the magnitude of the value factor’s underperformance was too big to be erased by exposure to any other factors. In spite of this, Dimensional had held on to its belief in the value factor. It has continued to employ a disciplined approach to gain diversified exposure to the market, and to emphasise parts of the markets with higher expected return as defined by stock’s exposure to each investment factor. In 2021, the fund's performances came back strongly due to its factor tilts.

If we take a look at the three core funds that represent the developed market, US market and Emerging Markets, we can see that the recovery of the value factor and the systematic tilts by the funds has led to impressive outperformance against the relevant benchmarks last year and year to date versus the historic performances.

How does Dimensional manage its funds?‍

We built the Endowus Factor Portfolios following a strategic and passive asset allocation framework, with the goal to provide investors with a well-diversified multi-asset portfolio suited for investors’ different risk targets. This asset allocation is meant for the long term and we will not tactically change it based on a short-term outlook on the markets. With the asset allocation in place, we leave the rest of the work to Dimensional who are experts in harvesting market beta and factor premiums consistently over time. So how does Dimensional do it, and do it well? 

On a high level, Dimensional’s process combines the best of indexing, such as broad diversification, low turnover, and transparency, with flexible active implementation to emphasise higher expected returns and manage risk. It is important to note that unlike pure factor strategies that narrowly invest in single factors exclusively, Dimensional actually buys the whole liquid, investable market to capture that broad market exposure first. Then, instead of weighting the securities based on market capitalisation, as is done by plain-vanilla index funds, they would weight the securities based on how much exposure it has to the proven factors of expected return. Hence, cheaper, smaller and higher profitability companies get more weightage in equities. In fixed income, they increase duration exposure when the yield curve steepens (as wider term spread implies higher term premium) and increase credit exposure when the credit spread widens (as wider credit spread implies higher credit premium).

However, the devil is in the details when it comes to factor investing. What really sets Dimensional apart is its sophisticated design, implementation, and risk management process.

Take the equities portfolio for example. The decision to target size, value and profitability premiums is just a starting point.  A myriad of questions come in when you consider how to incorporate these premiums in a real world portfolio. For example: 

• How do you weigh the different factors?
• Is it better to get exposure to the premiums by building standalone single factor portfolios and “mixing” them together, overlaying a satellite multi-factor portfolio on a market portfolio, or through an integrated approach that goes overweight on stocks with higher expected returns and vice versa across the entire market?
• How do you capture changing price information every day? (note: price to book, market cap and profitability ratios for each security would change as prices move and companies report earnings)

Dimensional makes deliberate decisions to each of the above questions based on robust research. For example, their research paper “Assessing the Relative Magnitude of Premiums” found “no reliable differences in the expected premiums, either individually or jointly, across US, developed ex US, and emerging markets” and “no reliable differences across premiums within any region or globally”.  This informs the weighting decision across different factors. Dimensional also found that an integrated approach of combining factors, which accounts for the interactions among multiple premiums and maintains a strong tie between security weights and market prices,  leads to greater reliability of outperformance, better risk control, and lower costs. This is how they implement their strategies. 

Dimensional’s portfolio management team has a daily rebalancing process centred on keeping the strategies consistently focused on the premiums they are intended to capture. While it is important to assess the changing factor exposures on each security and sell down those with lower exposure and purchase those with higher exposure, Dimensional balances such consideration with information on short-term and intra-day expected returns, as well as transaction cost. For example, even if a stock looks attractive on long-term factor exposure, if it is experiencing downward momentum on that day, it has lower short-term expected returns than its peers and it might be better off holding off the purchase temporarily. Such a process reduces unnecessary turnover, and allows for a flexible trading approach that enables opportunistic execution and minimises costs.

It is also worth mentioning briefly Dimensional’s process on the fixed-income front. Despite the popularity of factor investing in the equity market, factor investing in fixed income is still catching up in terms of asset size and its availability to retail investors. Dimensional has been managing fixed income assets since 1983 using a systematic approach, and its systematic fixed income strategies are now available for retail investors in Singapore via Endowus. 

There are many parallels between the fixed income and equity investing process, including the daily rebalancing process that’s critical in maintaining a continuous focus on higher expected returns efficiently. However, in fixed income, risks can be more clearly defined than equities, and Dimensional has a robust credit monitoring process to potentially exclude securities that are trading at a price that’s markedly lower than its peers, indicating a looming downgrade. This has proved to add value to its process and helped to mitigate unnecessary credit risk. 

Continuous innovation is in Dimensional’s DNA and we are encouraged to see the incremental improvements of their process, such as the implementation of the “investment factor” (exclusion of high asset growth stocks in the small-cap universe) in equities strategies, and their foray into lower quality bonds as the data becomes more abundant for systematic managers. Their rigour in research, focus on delivering better results for clients, and transparency in their process, are key pillars that provide us conviction and desire to partner with them on behalf of our clients.

Characteristics of Factor Portfolios by Dimensional

100-0 Endowus Factor Portfolio (100% equities allocation)‍

Firstly, a look at the 100-0 Endowus Factor Portfolio (100% equities allocation) shows that it is extremely diversified, with more than 10,000 names diversified across the developed and emerging equity markets. As previously explained, this provides great diversification benefits, and is the first step to harvesting market beta with controlled risk.

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The 100-0 Factor Portfolio also has balanced factor tilts to value, size and profitability. In aggregate, the portfolio’s average market cap is around US$40 billion compared with US$73 billion of the MSCI ACWI IMI Index representing the all-cap global equities market, and US$217 billion of the S&P 500 Index representing the US equities market. Its average price-to-earning and price-to-book ratios are also lower than the broad market indices, implying the value tilt relative to the market.

Investors also need to look under the hood and consider the interaction between the factors. For example, at first glance, it looks that the portfolio is of lower quality than the markets, as indicated by the return-on-equity figure. This is due to the interaction between factors — small-cap stocks generally have lower profitability, so an emphasis on small-cap exposure would naturally lead to lower profitability number on an aggregated  portfolio level. 

The chart below helps us to look under the hood and understand how in reality all three factors are targeted within the portfolio. Compared to the MSCI ACWI IMI Index, the portfolio is 2.59 times overweight in small caps and 0.82 times underweight in large caps, reflecting the size exposure. Within both large caps and small caps, there is a stronger emphasis on high-profitability names and value names compared with the index. For example, the portfolio is 2.67 times overweight for high-profitability growth names in small caps, versus only being 1.42 times overweight for low-profitability growth names in small caps. We need to understand that the overall overweight to small-cap growth names is due to the emphasis on small-cap stocks, and not on growth stocks. But within this specific segment of the market, the portfolio tilts towards names with higher expected returns as defined by the exposure to profitability factor. Such an integrated and nuanced approach of gaining factor exposures is what differentiates Dimensional’s strategies from the rest.

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0-100 Endowus Factor Portfolio (100% fixed income allocation)‍

Similarly, the 0-100 Endowus Factor Portfolio with 100% fixed income allocation is globally diversified with almost 900 holdings. Currently, the portfolio has a duration of around 6 years.

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The portfolio is an investment-grade portfolio, and Dimensional would adjust exposure to different credit rating buckets based on the relative width of the credit spread.

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The portfolio is global in nature, and this provides a larger opportunity set for it to add value. As different country’s yield curves would have different shapes at the same time, given the impact from different regional macroeconomic environments, the portfolio can therefore always target the yield curve and the exact point on the yield curve that offers the highest expected return.

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Finally, the portfolio tends to have more exposure to corporate bonds than government bonds.

Long term asset allocation performance and risk

We understand that investors are always anxious to see the historical live track record of the portfolios. However, the two funds in the Endowus Factor Portfolios are newly launched: the Dimensional Emerging Markets Sustainability Core Equities Fund (newly launched strategy) and the Dimensional US Core Equities Fund (the SGD share class is new, and the USD share class goes back to late 2015). So while we would love to provide a live track record of the portfolio for a longer period of time, unfortunately it is not possible. 

However, as previously mentioned, since all of our portfolios espouse a strategic and passive asset allocation, and since Dimensional systematically exposed the portfolio to the broad market beta, we can model the representative historical performance of the portfolio using asset class proxies when the live track-record is not available. The goal of this exercise is to help investors gauge longer term asset-allocation performance and risk, so as to make more informed investment decisions.

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The chart here displays such information and there are a few observations that can be made:

1. For 100-0 Factor Portfolio: the recent 3-month to 1-year performance displayed is on the more conservative side of  what the portfolio would have performed because it does not capture the strong value comeback in the emerging equities markets. This is due to the lack of the live track record for the  Dimensional Emerging Markets Sustainability Core Equities Fund. However, in the previous chart (Strong Recovery of Dimensional’s Strategy), we have used the Dimensional Emerging Markets Core Equities Fund to illustrate how Dimensional’s process has captured the value rebound in 2021 in the emerging equities market.
2. The longer term performance stats of the 100-0 Factor Portfolio is more or less in line with the expectation: it tracks the broad market with slight underperformance because of the lost decade for the value factor. 
3. For the 0-100 Factor Portfolio: its current duration exposure, which is 1-2 years less than the benchmark, is a headwind to its long-term representative historical performance as the past 10 years have been a great environment for taking on duration / interest rate risk as the interest rates fell. However, we believe that a slightly lower duration exposure in the current environment is helpful to the portfolio as we are likely to experience an increase in rates which will hurt duration exposure. ‍

Conclusion

‍Despite the various benefits of systematic factor investing, a common feedback we receive and what often prevents investors from allocating more to such strategies is the perceived complexity of the portfolios. We hope that the article has helped in removing some of that misunderstanding. Endowus client advisors are always here to answer your questions and to help you make more informed decisions. The Endowus Investment Office has worked hard to design the most optimal and well diversified Factor portfolio utilising the best systematic funds from Dimensional. As mentioned in the launch article, the Endowus Factor Portfolios by Dimensional is also the first discretionary portfolio that we’ve launched. This means we can more efficiently help our clients to upgrade their current investment portfolios if we find better or lower cost funds that can add value to the existing portfolio. This does not mean we will engage in tactical market timing or engage in active asset allocation and deviate from our strategic and passive asset allocation. Notification ahead of any changes, full transparency in the changes made, and communications through email and in-app, will also be made so that our clients will be fully aware of any changes made to our portfolios, whether big or small.

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