For decades we’ve known about the existence of factors that help to explain expected investment return. Factor based investing isn’t a new concept, but it is new to many investors. For one reason or another the terminology, which is widely recognized in financial academia, struggled to find mainstream adoption. Now things are beginning to change. Unlike the relentless stream of jargon invented by the financial industry, factor based investing describes an investment approach that’s grounded in science, as opposed to the many created to support Wall Street sales pitches.
The easiest way to understand factor investing is to first think about investment management in a very basic sense of passive or active. The two styles occupy separate ends of a spectrum representing not only the level of activity, but also the type. Factor based investing sits at the intersection, but in order to understand it, we must further define the opposite ends of the spectrum.
Pure Passive Index Investing
A pure passive approach applies a very simplistic philosophy. The goal is to closely track the market index in order to replicate its performance while mitigating as many fees as possible. Basically, buy it and hold it forever with virtually no activity or intervention. The predominant passive indexing method used today hasn’t evolved much over the last 40 years. Market cap weighting assigns a company’s exposure in the index by its size in the marketplace. The number of outstanding shares times the share price gives us a company’s market cap, which is then used to determine what percentage of exposure it gets in the index. Therefore, the largest companies have a bigger impact than the smallest. (For related reading, see: The Lowdown on Index Funds.)
Conventional Active Investing
Historically, we think about active investing in the context of predicting stock or asset class behavior based upon a number of fundamental or technical indicators. Significant subjectivity is placed in the hands of managers responsible for making decisions that add value, or alpha, above and beyond what could have been received by investing in the passive index. The manager's goal is to outperform. Doing so over long periods of time usually results in stardom and large amounts of fund inflows.
Passive index style investing has grown in recent years largely due to the evidence suggesting a failure of speculative active managers. Yet, it’s inaccurate to portray inactivity as a sound strategy based on this fact alone. Our understanding of markets has evolved significantly since the advent of index investing over 40 years ago. Every time a decision is made to adjust a portfolio in some way, the investor makes an active decision to move away from the pure passive end of the spectrum.
Factor Based Investing
Factor based investing seeks to answer the question: What are the intelligent active and passive decisions that can be made to improve the risk/return profile of a portfolio?
Factor based investors believe in making decisions based on the evidence reflected in large amounts of historical data. It positively pulls from both active and passive sides of the spectrum. Like passive, it strongly agrees that attempting to time the market is routinely impossible. Unlike a pure passive indexing, it recognizes the evolution in our understanding of factors that help to explain returns and actively structures investments to target them. (For related reading, see: An Introduction to Factor Investing.)
The conventional active investor believes in the possession of a skill which can be used to outsmart the market by seeing things others miss. The issue with this approach is that at some stage in the decision-making process a reasonable guess or gut feeling is involved. In contrast, a factor based approach references the data only, thereby removing much of the subjective human element.
The Supporting Evidence for Factor Investing
Factors such as the following help to explain the reward investors receive for the amount of exposure they maintain to the market as a whole—value companies, small companies and high profitability companies. The data going as far back as the 1920s reveals these effects which exist not only in domestic markets as listed below, but also across global markets.
Historical Performance of Factors Over Rolling Periods (U.S. Markets):
These examples make a strong case for structuring portfolios to target some specific factors. However, it’s important to remember that outperformance alone doesn’t justify omitting growth or large cap companies from a portfolio. The diversification benefits of owning stock in lots of companies across the growth, value and size spectrum, in addition to fixed income, is critically important to most investors for the reduction of portfolio volatility.
In its purest form, factor investing holds true to objective ongoing research that turns a blind eye to the name or even reputation of any company. Pioneers of this movement such as Nobel Laureates Harry Markowitz, William Sharpe, Eugene Fama and Kenneth French are unlikely household names, but they’re undoubtedly giants of modern finance. They, along with forward thinking industry titans like Vanguard’s Jack Bogle and Dimensional Fund Advisor’s David Booth, have helped make the practical application of empirical research possible.
Perhaps the most important thing to understand about factor based investing is that today’s research stands on the shoulders of yesterday. “Eureka moments" are few with most new developments coming as incremental improvements to well-founded ideas. I would issue a word of caution toward a financial strategy which regularly rushes products to market, citing new research without fully understanding its validity. Remember, Nobel Prizes don’t grow on trees. (For related reading, see: Smart Beta Fundamentals: Factors and Factor Investing.)
Factor based investing isn’t purely active and it isn’t purely passive but a marriage of intelligent research-backed ideas from both disciplines. It’s about taking what financial science has given us, evaluating the strongest ideas and filtering through thousands of solutions to find the best translation of those ideas.
It used to be a strategy reserved only for the wealthy sophisticated few. Today, investors from all walks of life have access to evidence-based investment solutions that are built on reason, not speculation.
(For more from this author, see: The Bull Market Anniversary and Long-Term Investors.)
Information provided by Dimensional Fund Advisors LP. Indices is not available for direct investment. Past performance is not a guarantee of future results.
Profitability is a measure of current profitability, based on information from individual companies’ income statements. In U.S. dollars. Based on rolling annualized returns using monthly data. Rolling multiyear periods overlap and are not independent. This statistical dependence must be considered when assessing the reliability of long-horizon return differences.
“One-Month Treasury Bills” is the IA SBBI US 30 Day TBill TR USD, provided by Ibbotson Associates via Morningstar Direct. Dimensional Index data compiled by Dimensional. Fama/French data provided by Fama/French. The S&P data is provided by Standard & Poor's Index Services Group. Eugene Fama and Ken French are members of the Board of Directors for and provide consulting services to Dimensional Fund Advisors LP. Index descriptions available upon request.