Making a Good Thing Even Better
As the public grows increasingly familiar with “passive” or “index” investing, it’s becoming easier for individual investors to gain cost-effective exposure to globally diversified market returns. That’s good news! Even better news is that there is a similar approach we employ for our clients that incorporates the many strengths of passive/index investing while eliminating some of its inherent weaknesses. Beyond passive, we call it evidence-based investing.
More than any other approach, we feel that evidence-based investing rigorously incorporates available evidence on how markets have delivered long-term wealth to patient investors. Our aim is to combine sound strategy with objective advice on how to best apply it, so you can tune out harmful distractions and confidently pursue your own highest financial goals.
A Brief History of Indexing
To understand how evidence-based investing works today, it’s helpful to review where it came from. Before there was any form of passive investing, there was active investing. Active investors try to profit by predicting where and when they’re going to experience future gains and losses, and proactively trade in and out of securities, sectors or markets to stay one step ahead. While the idea may seem appealing, there are reams and decades of academic evidence demonstrating that the tactic simply doesn’t reliably work, especially after factoring in costs.
In the early 1970s, the first index funds were formed to offer investors a better choice. As the name implies, an index fund buys and holds the securities tracked by a particular index, which is seeking to reflect the performance of a particular asset class. For example, the earliest index funds tracked the popular S&P 500 Index – which in turn tracks the asset class of U.S. large-company stocks. Over time, additional index funds (and similar Exchange Traded Funds, or ETFs) have emerged to track a host of other indices, representing a wide range of asset classes.
Many index funds are well-suited alternatives to actively managed funds, offering tighter control over the actions that academic evidence indicates are critical to expected outcomes:
Asset allocation – How you allocate your portfolio across various market asset classes plays a far greater role in varying your long-term portfolio performance than does the individual securities you hold.
Global diversification – Through broad and deep diversification, the sum of your whole risk can actually be lower than its individual parts.
Cost control – The less you spend implementing a strategy, the more you get to keep.
Understanding the Market Factor
Let’s take a closer look at one of the fundamental building blocks of both index and evidence-based investing: the market factor.
Broadly speaking, the “market factor” refers to the idea that, over time, stocks as a whole tend to provide higher returns than bonds or cash equivalents. Decades of research have shown this premium exists because investors demand compensation for accepting the higher risks that come with owning stocks. Legendary academics such as William Sharpe (with his Capital Asset Pricing Model) and Eugene Fama and Ken French have explored these patterns in detail, demonstrating that, historically, stock markets have rewarded patient investors willing to weather short-term ups and downs.
Why is this the case? Unlike bonds, which essentially pay a fixed stream of interest in exchange for less risk, stocks represent ownership in companies and, by extension, a claim on their future earnings. As businesses grow and profits rise, the value of those ownership stakes generally increases over the long haul—albeit with more volatility along the way. That’s why, through good markets and bad, ownership in a diverse pool of stocks continues to offer the potential for greater long-term growth compared to their safer, more predictable bond counterparts.
Inherent Weaknesses in Index Investing
So far, so good. But there are at least a couple inherent weaknesses to index funds.
Index Dependency – Most index funds are generally cost-effective compared to active strategies. But, by definition, they track an index. Whenever that index “reconstitutes” by changing the underlying stocks it is following, the funds tracking it must do so as well – and quickly. In a classic display of supply-and-demand pricing, this generates a buy high, sell low environment as index fund managers must queue up to simultaneously sell stocks that have been removed from the index and buy stocks that have been added.
Compromised Composition – Asset class investing is based on the premise that particular market asset classes exhibit particular return characteristics over time. For example, academic evidence has demonstrated that the stocks of distressed, small-companies are perceived as riskier than stocks of thriving, large companies. So investors demand – and have by and large received – a premium return for investing in these riskier factors.
An index seeks to accurately proxy the asset class it is targeting. But it’s still just a proxy. The S&P 500, for example, tracks 500 U.S. large company stocks out of the roughly 5,000 stocks available for trading on a U.S. exchange. Tracking an index enables pretty good exposure to a targeted asset class, but there’s room for improvement by a fund manager who can capture a larger, more accurate representation of the asset class being targeted.
Bond Maturity, Volatility, and Risk-Adjusted Returns
When it comes to bonds, there’s a classic trade-off between risk and reward—one that academic research has explored in depth. In particular, studies have found that bonds with shorter maturities and lower price volatility often provide stronger risk-adjusted returns compared to their longer-term, more volatile counterparts.
The reasoning is fairly straightforward. Short-term bonds are generally less sensitive to interest rate changes and market fluctuations, making them more stable overall. Their lower volatility means that, even if they don’t always offer the highest headline yields, the returns they do generate tend to be more consistent for the amount of risk taken.
These observations aren’t just theoretical. For example, research published in the Journal of Fixed Income has shown that, across major global bond markets, lower-volatility bonds—often those with shorter maturities—have historically produced outcomes that reward investors more per unit of risk taken, compared to riskier, longer-dated issues.
This preference for stability helps inform a more evidence-based approach to building fixed income portfolios—seeking not just return, but a smoother ride along the way.
The Advance of Evidence-Based Investing
It didn’t take long before academically minded innovators from around the globe sought to improve on the best traits of index funds and eliminate their weaknesses. In fact, many of these thought leaders were the same early adopters who introduced index fund investing, to begin with.
Who’s Behind Evidence-Based Investing? The Academic All-Stars
Much of what we now know as evidence-based investing is grounded in decades of rigorous research by some of the brightest minds in finance and economics. These trailblazers—from Nobel Prize winners to pioneering academics—have shaped our understanding of markets, risk, and return.
Leaders in the field include the likes of Harry Markowitz, whose Modern Portfolio Theory laid the foundation for understanding diversification; Eugene Fama, often called the “father of efficient markets”; and Daniel Kahneman, whose work in behavioral finance dissected the quirks of human investing behavior. Other Nobel Laureates such as Merton Miller, Franco Modigliani, and Robert Merton have further illuminated the factors influencing returns and capital allocation.
The field has also been enriched by forward-thinking scholars and practitioners: Myron Scholes and Paul Samuelson advanced our grasp of pricing and risk; Richard Thaler and Robert Shiller explored the human side of investing; and innovators like Ken French, Cliff Asness, Andrew Ang, and Robert Novy-Marx have expanded the practical application of academic insights.
Put simply, the principles of evidence-based investing aren’t plucked from thin air—they’ve been carefully constructed atop a mountain of peer-reviewed research and practical experience, thanks to this impressive roster of thinkers.
The results are evidence-based investment funds, which offer us several advantages:
Index-independence – Evidence-based fund managers have freed themselves from tracking popular indexes. Instead, they have established their own parameters for cost-effectively investing in the lion’s share of the securities within the asset class being targeted. This reduces the need to place undesirable trades at inopportune times simply to track an index; it allows them to employ more patient trading strategies and scales of economy to achieve better pricing.
Improved Concentration – Untethering themselves from popular indexes also enables evidence-based fund managers to more aggressively pursue targeted risk factors; for example, an evidence-based small-cap value fund has more flexibility to hold smaller and more value-tilted holdings than a comparable index fund. This provides us with more refined control as we construct clients’ portfolios according to their individual risk/return goals.
Focusing on Innovative Evidence – We firmly believe that investors are best served when we make it a top priority to heed the evidence on how markets have delivered long-term wealth. Evidence-based investing shifts the emphasis from tracking an index, to continually improving our understanding of the market factors that contribute to the returns we are seeking. By building portfolios using fund managers who apply this same evidence to their fund constructions, we feel we can make the best use of the academic insights we already know, while efficiently incorporating credible new ones as they emerge.
Momentum: Harnessing Recent Winners
Another market force that academic research has illuminated is momentum. In essence, momentum refers to the observed tendency for stocks and bonds that have recently outpaced their peers to continue outperforming—at least for a while. This phenomenon has been rigorously studied in both equities and fixed income, with compelling evidence showing that securities exhibiting strong recent returns often sustain their winning streaks in the short term.
Notable studies, such as those by Jegadeesh & Titman (1993), have shown that strategies favoring recent winners and avoiding recent losers can lead to meaningfully higher returns. More recent research has confirmed that these trends aren’t limited to a single asset class—momentum shows up in stock markets, bond markets, and even across global markets (see: Asness, Moskowitz, & Pedersen, 2013; Brooks, Palhares, & Richardson, 2018).
Incorporating an understanding of momentum into portfolio construction enables us to thoughtfully tilt allocations, seeking to capture this persistent edge while carefully managing the risks that come with it. This is yet another example of how academic insights lead to practical, evidence-based improvements in investment strategy.
The Value of Factor Diversification
While asset class diversification is a familiar tenet—spreading your investments across different areas of the market to manage risk—factor diversification adds another, more nuanced layer to prudent portfolio construction.
So what are “factors”? In a nutshell, factors are specific, measurable characteristics of stocks or bonds—like size, value, momentum, or credit quality—that academic research (think Fama, French, and their colleagues) has identified as drivers of long-term returns and risk profiles. For example, smaller companies or those considered undervalued compared to their fundamentals have shown, historically, to carry additional risk but also offer the potential for higher returns over time. The same goes for other attributes, such as companies displaying consistent profitability or certain measures of volatility.
Why blend multiple factors alongside asset classes?
No single factor outperforms in every market environment. Just as placing all your chips on a single asset class can expose your portfolio to unnecessary volatility, relying solely on one or two factors may subject your investments to periods of underperformance. By diversifying across a range of factors—such as value, size, momentum, and quality—investors can:
Harness a broader set of potential return sources
Reduce the likelihood that poor performance in any one factor will derail their overall portfolio
Smooth out the ride by balancing strengths and weaknesses across economic cycles
In short, thoughtful factor diversification is a complementary strategy to asset class diversification, aiming to stack the deck in your favor by tilting the odds—based on robust, long-term evidence—toward a more consistent investment experience.
The Role of Quality in Investment Performance
Focusing on the “Quality” Factor – Another key insight from academic research centers on the concept of “quality” within both stocks and bonds. The evidence is clear: investments in companies that demonstrate higher-quality characteristics—such as strong profitability, healthy balance sheets, and prudent management—tend to deliver better long-term returns compared to their lower-quality counterparts.
Multiple studies, including influential work by Robert Novy-Marx (“The Other Side of Value: The Gross Profitability Premium” in the Journal of Financial Economics, 2013) and research led by Clifford Asness and colleagues (“Quality Minus Junk” in the Review of Accounting Studies, 2019), have shown that emphasizing quality in portfolio construction provides an added layer of expected return. For stocks, this means favoring firms with robust earnings and stable financial practices. For bonds, similar principles apply—higher-quality issuers tend to offer more resilient performance, especially in volatile markets.
Incorporating the quality factor allows fund managers more precise navigation as they seek to boost returns while managing risk. By prioritizing high-quality companies, portfolios may achieve steadier growth and avoid some of the pitfalls that come from holding weaker, financially distressed firms.
This approach further aligns with our evidence-based philosophy: if decades of data show that focusing on quality improves outcomes, it makes sense to systematically embed this advantage into our investment process.
The Minimum Volatility Factor: Smoother Sailing for Savvy Investors
Let’s turn our attention to another compelling dimension of evidence-based investing: minimum volatility. The idea here is refreshingly straightforward—by focusing on investments that go through fewer wild price swings, you may actually achieve better risk-adjusted returns over time.
Academic research adds weight to this approach. For instance, a notable study by Ang, Hodrick, Xing, and Zhang (2006) demonstrated that stocks with lower price volatility have historically delivered superior risk-adjusted performance compared to their more turbulent peers. In plain English: minimum volatility stocks might not always win beauty contests in bustling bull markets, but they tend to lose less sleep (and value) when the going gets rough. Over long stretches, that smoother ride can add up to a more comfortable and successful investment experience.
The same principle holds up in the world of bonds. Shorter maturity and lower volatility bonds, as research by de Carvalho and colleagues (2014) highlighted, have typically provided a more appealing balance between risk and reward than their longer-term, higher-volatility counterparts. So, whether you’re dealing with stocks or bonds, harnessing the minimum volatility factor can help tilt the odds in favor of a calmer journey and steadier returns.
By deliberately weaving these insights into portfolio construction, we seek not only to capture market returns, but also to help investors better withstand the inevitable storms along the way.
Credit Risk: Unlocking a Key Dimension in Bond Returns
Let’s turn our attention to credit risk—a factor that often flies under the radar but has meaningful implications for bond investors. In plain English, credit risk is the chance that a bond issuer might not be able to pay back its debts. When a company or government has a lower credit rating, it suggests a greater possibility of default compared to higher-rated, “safer” issuers.
From an evidence-based perspective, bonds carrying higher credit risk (think lower-rated corporate bonds or emerging market debt) tend to offer higher yields to compensate investors for bearing that extra uncertainty. Academic research, such as the work of Antti Ilmanen in Expected Returns, highlights a long-term trend: Over extended periods, bonds with lower credit quality have on average delivered higher returns than their higher-rated counterparts.
What’s behind this return premium? Investors demand extra reward to offset the potential pain of missed payments or even outright default. While this premium doesn’t guarantee that every “riskier” bond will outperform every “safe” bond, the broader data shows that, by diversifying thoughtfully and understanding the nature of credit risk, investors have historically been able to capture this additional return.
Of course, market conditions and timing can play a role, and higher returns come with bouts of added volatility and risk. Still, for those comfortable with the trade-offs, carefully managed exposure to bonds across the credit quality spectrum can be a valuable lever in pursuit of long-term growth and income.
What the Evidence Shows About Interest Rate Risk
When it comes to bonds, one of the most important considerations is their sensitivity to changes in interest rates—often referred to as interest rate risk. In a nutshell, bonds with longer maturities or durations are more sensitive to movements in interest rates than their shorter-term counterparts.
Academic research, including the work of Antti Ilmanen in Expected Returns, has shown that, over the long run, longer-duration bonds have generally offered higher returns than shorter-term bonds. The rationale is straightforward: investors require compensation for the greater uncertainty (and potential price swings) associated with holding bonds that are more exposed to rising or falling rates. This premium, however, can come with increased volatility along the way—meaning the journey to better long-term returns may not always be a smooth one.
As we apply these insights, it’s important to consider your own tolerance for risk and the role bonds play in your broader portfolio—whether you’re seeking a steady anchor or looking for a bit more return potential from your fixed income allocation.
Selecting and Blending Top Investment Managers
To construct the strongest possible portfolios, we apply a disciplined process to handpick investment managers based on their demonstrated expertise in specific asset classes and unique sources of return. Much like assembling the ideal orchestra, each manager is selected for their proven ability to excel in their domain—whether that’s harvesting value premiums, navigating small-cap terrain, or delivering cost-efficient fixed income exposure.
By thoughtfully blending these specialists—some, for instance, with decades of experience at the likes of Dimensional Fund Advisors, Vanguard, or AQR—we are able to craft a diversified mosaic designed to maximize risk-adjusted returns. This collaborative approach helps ensure your portfolio draws from a broad pool of insights, all while keeping a close eye on costs and transparency. The result is a strategy that isn’t just intellectually sound on paper, but one that is grounded in practice and stands the test of time when faced with ever-changing markets.
A Final Word: Investor Behavior
In many respects, the most important factor driving your investments has nothing to do with market factors. It has to do with your state of mind.
To build or preserve sustainable wealth in ever-volatile markets calls for a disciplined outlook based on:
1. Your ability to adhere to a long-term plan.
2. The ongoing management of market risks.
3. An investment approach that minimizes the costs involved.
To help you achieve and sustain this challenging level of investment discipline, we take it as our honor and our duty to advise your investing according to reason, based on the best available evidence on how markets work, applied by fund managers who do the same. That’s evidence-based investing.