I recently read Andrew Berkin and Larry Swedroe’s Your Complete Guide to Factor Based Investing. I’ve written about factor investing before, and this book provides a great summary of the value of factor investing and some ideas of how to implement it within your portfolio.
In short, “factors” are properties or a set of properties common across a broad set of securities. Although there are hundreds of factors, only a few have reliably explained the performance of stocks over a long period of time. Berkin and Swedroe analyzed dozens of factors and concluded that certain factors, such as momentum (positive momentum is better than negative momentum), market beta (low beta is better than high beta), and quality (high quality, such as high cash flow to assets, is better than low quality), tend to outperform other factors such as size (the smaller the better) and profitability (more profitable better than less profitable), even though those factors are also valuable. Ultimately, combining factors gives the best combination of return and diversification. If an investor were to take advantage of multiple factors, then the investor could reduce his or her stock market exposure but receive a similar rate of return with less risk overall. As such, investors should view their portfolio less as a collection of asset classes to be diversified and more as a collection of diversifying factors.
One major critique of factors is that they either tend to fade over time or at least trend positively or negatively. In other words, as investors learn about a given factor’s success, they (in the aggregate) tend to invest more in stocks exhibiting that trait or property, thereby arbitraging it away. While this may be true for some factors, for others the behavioral reasons that the factor exists are sufficiently strong that it keeps most people from investing in that factor. A simple example is the value factor, in which high value stocks are often out of favor, and as a the result people tend to shy away from those stocks at least for some period of time. This behavioral tendency to stay away from stocks that have performed poorly keeps the value factor intact. That some factors tend to fall in and out of style is yet another reason to diversify across factors, but it is not a reason to stay away from them.
Unfortunately, factor investing is often too expensive. There are some very inexpensive ETFs and index funds that have a natural quality, value and/or size tilt; however, most multi-factor funds have such high expense ratios that it is not clearly worth it. Investors with significant assets might be able to create their own multi-factor fund using multiple low-cost ETFs that target just one or two factors each. For the rest of us, until their costs come down, most people are best served avoiding “smart beta” and other similar funds. Even then, investors need to diversify across factors just as they diversify across asset classes.