Factor Investing – I would like to thank Gregory A. Johnston, CFA®, CFP® for sharing his thoughts on Factor Investing. At Reh Wealth Advisors LLC, we use some of the principles of factor investing and have used value and small tilts to our portfolio. If you are in the Illinois area and looking for great Fee-Only Planner be sure to look up Gregory and Johnston Investment Counsel. Thanks for the great article Gregory,
One of the newest things (I will refrain from using the word fad) in the investment world is the proliferation of factor investing. It seems that every exchange-traded fund (ETF) firm has created a suite of ETF’s that seek to emphasize factor investing.
What Are Investment Factors?
An investing factor is simply a characteristic. It could be a fundamental or technical characteristic. A fundamental factor will use data from a company’s income and/or balance sheet while a technical factor would likely use some form of historical price change. There literally are hundreds if not thousands of potential factors. Examples of possible fundamental factors could be price / sales, and price / earnings. Technical factors could be price change over the past 13 weeks as well as a calculation of momentum.
Why Do I Care About Investment Factors?
During the past few decades, academic researchers have identified certain factors that historically have outperformed other factors. The factors identified as having outperformance characteristics include: value, low size, quality, momentum, low volatility, and high yield. So, over time, if an investor held a portfolio of these “factor tilts” they may have outperformed an index.
It is imperative to understand that the previously mentioned factors have been identified as historically providing excess risk-adjusted returns. That does not mean these excess returns will be repeated into the future nor does it mean these factors outperform each and every year. In fact, many of these factors will have several years where the factor may be out of favor. So an investor will need patience to earn the possible factor outperformance.
How Are the Funds Created?
As previously mentioned, there has been a widespread increase in the number of factor-investing ETF’s. Many firms will create a single factor ETF (think just value or momentum) while others will create a multi-factor ETF that seeks to combine multiple factors into a single portfolio.
Regardless of whether the ETF is a single or multi-factor fund, how the factors are defined and the portfolio is constructed is of critical importance. There are several things investors should evaluate:
- What characteristic(s) are used in creating the specific factor? For example, assuming a value-factor fund, is a single company characteristic used or are there other value characteristics that are averaged or perhaps weighted in some way?
- Are there company size parameters in creating the universe of potential holdings?
- How does the manager determine the number of holdings?
- How does the manager deal with potential sector concentration (or lack of sector allocation)?
- How often is the portfolio re-scored and rebalanced?
Most of the factors mentioned have been extensively researched and have historically provided excess returns. However, investors should be aware that:
- While historically providing a return benefit, that has no predictive power for the future
- Now that there are many factor-based funds, using similar factor characteristics, will the “factor benefit” simply be arbitraged away because of the higher demand for that factor?
- A factor does not necessarily outperform each day, month, or year. So an investor will need to have a degree of patience during those periods of underperformance.
With those caveats, investors might be able to identify specific factors that are in-/out- of favor at specific points in time and over-/under- weight a specific factor.
While the significant increase in the number of funds gives us a significant amount of pause, we believe these factor investing funds do bear watching and, when thoroughly evaluated (including underlying expense ratios), may be a reasonable addition to a portfolio.
On our website, there are links to a variety of investment-related information and articles.
About the Author
Gregory A. Johnston, CFA®, CFP®, CPWA®, QPFC, AIF® has over 25 years of investment and comprehensive finanical planning experience. He started Johnston Investment Counsel in 1997 as an independent, fee-only investment management and comprehensive planning firm located in Peoria, Illinois. His clients include individuals, retirement plans, and endowments / foundations.