Introduction

Index funds are an increasingly popular and undoubtedly sensible tool for building investment portfolios. The push toward index investing is based on the Efficient Market Hypothesis (EMH) (Fama, 1970), which simply states:

In general terms, the ideal is a market in which prices provide accurate signals for resource allocation: that is, a market in which firms can make production-investment decisions, and investors can choose among securities that represent ownership of firms’ activities under the assumption that security prices at any time “fully reflect” all available information. A market in which prices always “fully reflect” available information is called “efficient.”

If the market is efficient then prices contain all relevant information about the expected returns of a stock at that point in time. Price changes will be based on new information, which cannot be predicted reliably. In an efficient market it is not possible to earn reliable excess returns without taking on excess risk. Excess returns without excess risk, known as alpha, is the goal of traditional active management. Active management involves some combination of selecting a subset of stocks and timing the market to generate alpha.

The consistent failure of active management to generate persistent alpha, as documented by Carhartt (1997) and Fama and French (2010), supports market efficiency. As investors have become increasingly aware of the empirical failure of active management, and its theoretical implications, they have rightfully shifted their dollars toward low-cost broadly diversified index funds. This shift is sensible given the pervasive evidence of market efficiency.

We would stop here to arrive at the conclusion that index investing is the smartest way for most people to invest. If it is nearly impossible to consistently generate returns in excess of those associated with taking on risk, then it is sensible to minimize costs and maintain long-term exposure to known risks. Index investing using a market capitalization weighted index fund, like the iShares ETF XIC tracking the S&P/TSX Composite index for Canadian stocks, offers low-cost exposure to market risk.

Since the introduction of the EMH as a falsifiable model in the mid-1960s, the field of asset pricing has revealed other theoretically consistent and empirically robust risks that systematically affect asset prices, independent of market risk. This is where an evidence-motivated investor may choose to diverge from the basic concept of market capitalization weighted index investing. Rather than taking on only market risk, it may be sensible to pursue long-term exposure to a combination of independent risks.

Considering the increasing correlations of global stock markets, exposure to multiple risk factors may be even more beneficial than exposure to the stock markets of multiple countries. Combining risk factor diversification with geographical diversification will provide investors with greater diversification benefits than market capitalization weighted index funds alone. This paper will introduce the risk factors included in a prominent asset pricing model, the Fama French Five-Factor Model, and the empirical case to include exposure to these risk factors in portfolios. We will propose a model portfolio of ETFs that aims to achieve exposure to all five independent risk factors.

Contributors