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Pragmatic Capitalism

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Factor Investing – Tilting at Windmills

(I hope you have your big boy pants on today because I am about to unleash another beat down on factor investing. I apologize in advance to all my colleagues in finance who love factor investing so much.)

Factor investing is all the rage these days. If you don’t know what it is, stop being such a loser and get with the times.¹ Factor investing involves allocating your portfolio to certain “factors” that have been shown to generate excess returns. The most popular factors are value, size and momentum, but there are hundreds to choose from. In the last 10 years there has been an explosion in new funds selling you excess returns in exchange for higher fees. And while it’s easy to come up with an academic theory about generating alpha the reality is that it’s very hard to create an actual fund that captures that alpha. I got to thinking about this while reading this fantastic post by Wes Gray showing that a high number of factor funds are closet index funds. The SPIVA Scorecards also strongly support this view:

  • The Annual SPIVA scorecards show that 78%-99% of different factor funds fail to beat their benchmarks over a 15 year period.*

Of course, the defenders of factor investing will say that most of these funds don’t implement the factors correctly. But that’s what alpha salesman always say – “those other guys just don’t do it right so pay me the high fees and give me a chance!”  But the evidence clearly shows that those selling equity alpha cannot consistently generate the high returns they promise.

This makes absolute sense. A stock is just a claim on a corporation’s cash flows. Corporations will appear different at different stages in their lives, but it’s very difficult to build a diversified portfolio of stocks and know whether you own the corporations that are actually “growth” or “value” or whatever.² This is why market cap weighted asset allocation works so well – you take the guesswork out of the equation. You don’t need to pick which factors are the best or the worst because you own them all.  That’s the beauty of diversification. You don’t need to own the best stuff. You just need to own enough of the best stuff to generate good results.  All the while you’re saving bigly on fees which is where the real excess return comes from relative to high fee funds.

As an example of why stock market factor investing is difficult let’s look at the bond market. The bond market is made up of specific contractual obligations that are designed to perform a specific way over specific periods of time. When you buy a 10 year T-Note you know almost precisely what you’re getting. You can tilt your portfolio to match your specific needs. You know, with much greater precision, what the “factors” are that drive those returns. This does not exist in the stock market. You can’t match your needs to a time horizon or return because a stock is essentially a perpetual contractual obligation with no guarantees.

And that’s the big issue here. Factor picking has become the new stock picking. And when it comes to factor investing the asset manager still has to pick the right stocks that will match whatever “factor” they’re trying to replicate. So, factor investing is actually just stock picking by a different name. And there is clear evidence that asset managers are not very good at picking stocks whether they’re growth, value or whatever. As a result, tilting to factors in the stock market is a lot like tilting at windmills.³

When it comes to picking stocks I say simple is better. Stick to low fee market cap weighted index funds and if you need to tilt it make sure you the only thing you tilt is your allocation so it matches your risk profile rather than tilting it to try to match an excess return that you probably won’t achieve, but will definitely pay higher fees for.

¹ – I don’t like factor investing which I guess means I am not one of the investment cool kids these days. That’s okay. Come join me in the loser’s circle. I’ll bring the sad trombone and you guys can buy the beer with all the money you saved on fees by not investing in factor funds.**

² – Most factor investing is based on extrapolative expectations. That is, running some sort of backtest and filling in the companies that fit a certain profile in the past. Whether or not these stocks will meet that criteria in the future is a whole different story and not an endeavour I trust any asset manager to successfully accomplish.  

³ – For those of you who are too young for this reference do yourself a favor and buy this

* – Some people have noted that the SPIVA scorecards are a non-standard way of judging factors. While this might be true it does not mean that the “value” and “size” funds being scored are irrelevant. After all, there is no standard definition for factor investing and even Gene Fama has changed the number of factors over time. That said, there are many different ways to implement size, momentum, value and the multitude of other factors. And as I noted previously, the various iterations of these strategies are nothing more than active management by another name. Those selling these active strategies in exchange for high fees should not be expected to perform any better than the long list of poor performing high fee managers in the SPIVA scorecards.  

** – Disagreeing on factor investing is a bad position for me to take. If I were a smart person I would just read Fama, Asness and all the smart kids, nod my head, agree like a good boy and spread the message. Strangely, that isn’t my style. Maybe I’ve read too much Carl Sagan who once said:

If we are not able to ask skeptical questions, to interrogate those who tell us that something is true, to be skeptical of those in authority, then, we are up for grabs for the next charlatan (political or religious) who comes ambling along.”

NB – I should add a caveat here. I am not against active deviations from market cap weighting. What I am against is high fee deviations from market cap weighting. If you can diversify in reasonably priced factor funds I am not necessarily against that. The real problem here is the high fee factor funds that purport to generate alpha in exchange for those high fees.

Cullen Roche

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC.Orcam is a financial services firm offering low fee asset management, private advisory, institutional consulting and educational services.Cullen is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.
Cullen Roche

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