One of the hottest trends in finance today is “factor investing”. This is the idea that you can generate market beating returns by understanding the fundamental drivers of stock returns that lead to higher returns than a market cap weighted portfolio. For instance, it’s been shown that value, size, momentum and other factors lead to better performance. Although this approach is supported by substantial academic evidence I don’t love using this approach and I’ll outline why.
- Factor Investing is Unnecessarily Complex. Market cap equity investing is simple and has a time proven track record of beating more active strategies over long time horizons.
- Factor investing is becoming the new active investing. In a world of index funds we no longer pick stocks. But we do have to pick which index funds we invest in. A factor fund is comprised of components that a manager picks and packages as a product. Whether that manager can consistently pick the stocks that will best represent that factor is no different than any other form of stock picking. In most cases this just means less tax and fee efficiency because the manager is dealing in smaller economies of scale.
- Factors can and will fail for very long periods of time. The value factor has experienced a 15 year drought. So all of those investors who “picked” value funds 15 years ago have undergone an unnecessary period of poor relative performance. So this begs the question – if factors can underperform for long periods of time then why would you own just one factor? But that raises another problem. The more factors you own the more your portfolio looks like the market cap weighted portfolio and the lower your odds of beating the market cap weighted fund. What purpose does all this guesswork achieve?
- Beating the market is not a financial goal. Factor investing promises the hope of market beating returns in exchange for the guarantee of higher taxes and fees. Since beating the market is not a financial goal it’s hard for me to justify why portfolio managers should try to beat the market on behalf of their customers.
- Trying to beat the market creates a conflict of interest. When a fund manager tries to beat the market they are protecting themselves from the career risk that they are judged upon – whether they can outperform a less active correlated benchmark. But this creates a conflict between the way the customer perceives risk and the way the manager perceives risk because the customer views risk as the potential for permanent impairment of capital. If the manager takes more risk in an attempt to beat the market then they have increased the risk of permanent loss which means they are not managing risk in the way the client expects.
- Factor investing works in theory, but is far less reliable in practice. There are very few factor funds with a long track history that confirms what the academic backtests and research show.
Now, in fairness, I think most investors will inevitably tilt away from a true global market cap weighting portfolio for perfectly practical reasons. There’s nothing wrong with that and many “factors” will drive this reasonable deviation. So it would be unfair of me to broadly bash factor investing. That said, as a general rule I think it’s safe to say that factor tilting at a reasonable cost is a reasonable deviation whereas factor tilting at a high cost is an unreasonable deviation. In other words, a little tilting from market cap weighting is fine so long as it doesn’t result in debilitating taxes and fees.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He 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.