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Market Commentary: The Attraction of Factor Investing

Market Commentary: September, 2019

The Attraction of Factor Investing

By: Peter Nielsen, MBA, CFA®

 

Invention and innovation continue to change the world around us. However, it’s often forgotten that there is generally a significant time lag between the date a product is launched and when it makes an impact on society. For example, Wilbur and Orville Wright designed, built and flew the world’s first airplane at Kitty Hawk, North Carolina in 1903. It transformed the world. Yet, in 1903 there was no recognition of the significance of the event. It received no acknowledgement in the press. It wasn’t until 1906 that the New York Times even mentioned the Wright brothers’ achievement.

While not all major advancements are accompanied by the apathy the Wrights experienced, it is not uncommon. Alexander Graham Bell tried to sell his invention of the telephone to Western Union who responded that the “telephone has too many shortcomings to be seriously considered as a practical form of communication. The device is inherently of no value to us.” Henry Ford championed the “horseless carriage” (automobile) only to be told by Congress that his invention was a “menace.”

 

The world of finance has seen such moments as well. John Bogle launched the first index fund in 1975 with little fanfare and little initial success. It wasn’t until 20 years later that index funds started to dominate the investing landscape.

 

Another fast-growing area of finance is “factor investing” (or “smart beta” investing). Its genesis stems from research published more than 25 years ago by Eugene Fama and Kenneth French (“The Three Factor Model”). The authors found that “factor betas” for value stocks and small company stocks improved risk adjusted returns. This led academics to start thinking about other factors that might contribute to higher stock returns. For example, academics found winning stocks continue to rise and losing stocks continue to fall (the “momentum factor”). Over a period, investing in winners and avoiding losers often results in higher returns for a given level of risk. So, factor investing became an approach to investment management that relied on financial, market or other quantitative attributes to manage portfolios.

 

The flow of money into factor strategies has been staggering. According to Morningstar, assets in factor- based strategies have grown from $150 billion in 2011 to over $800 billion today. Why might it be garnering so much interest? Probably because investors have been disappointed in the performance of traditional active managers. Factor driven financial products offer the prospect of improving upon market returns without the headache of trying to find the next Warren Buffett.

 

Reasons for caution:
In the years since the publication of the “Three Factor Model”, many other so-called “factors” have been identified. Not all are credible. Others have less significance now than when they were first “discovered.” For example, small company stocks no longer earn the excess return they did when Fama and French published their original paper in 1993.

 

Some suggest that Factor Investing is another form of passive investing. On the surface, it might appear to be passive but in reality these portfolios are just another form of active management. Any time an investor deviates from the market, they are employing an active investment strategy. Confusing the issue are the names some of these financial products bear. Names like “fundamental index” are suggestive of a passive index product, when they are just another class of actively managed mutual funds or ETFs.

 

Factor Investing at Foster Victor:
Foster Victor uses factor-based financial products sparingly. In our view, factor-based funds must serve a specific purpose within an overall portfolio before they can be included. We believe factor investing can add value within a multi-asset class investment strategy. We have also crafted a strategy that uses momentum to allocate capital to assets across a portfolio. The model tests a diverse set of asset classes and chooses only those that show evidence of positive momentum. In our research, we have found momentum, or the tendency for a financial asset to continue to rise or fall, has been persistent in its ability to mitigate some of the effects of market downturns.

 

Like so many other innovations, it took factor investing many years to go from an idea to broad use and acceptance. The growth and attraction of factor investing reflects its success. What will the future hold? Will factors such as momentum continue to generate positive risk premiums for investors? No one can say. However, we don’t believe capital markets are perfectly efficient and this suggests there may be opportunities to enhance overall portfolio strategy.
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