Consider, for example, the two value factors. The characteristics-based value factor earns an average return of 2.9% a year and is statistically significant with a t-value of 2.05. The beta-based value factor, by contrast, earns an average return of just −0.2% a year with a t-value of −0.15. Whereas the standard versions of value, profitability, investment, and momentum all earn statistically significant returns at the 5% level, none of the beta-based versions do.
A possible explanation for the similarity in the characteristics- and beta-based metrics for the size factor is the close correlation in firms’ size (SMB) betas with size characteristics, whereas the other factors’ betas do not strongly correlate with their corresponding characteristics. A sort on SMB betas produces portfolios with very similar compositions to the portfolios formed by sorting on firm size.
An equally weighted portfolio of the five characteristics-based nonmarket factors, rebalanced monthly, has a Sharpe ratio of 0.82 (t-value = 5.94) compared to the equally weighted portfolio of beta-based factors, which has a Sharpe ratio of just 0.09 (t-value = 0.67).
Now, let’s turn our attention to risk-adjusted returns. Although the beta-based factors appear unattractive in terms of their average returns and Sharpe ratios, their loadings against other factors may change an investor’s assessment of their potential to add value in a portfolio. A factor’s low average return, if it has a sufficiently low or even negative correlation with any of the other factors the investor holds, may render it an attractive investment option (Markowitz, 1952).