Factor investing is a specific way to approach investing.
This approach targets specific drivers of returns across asset classes and can help improve returns and enhance diversification.
How does factor investing differ from traditional investing?
When looking at investing styles, there are two ends of the spectrum. At one end, you have purely active managers. These managers will only invest in a select few companies based on a deep analysis of their prospects. On the other hand, you have passive managers. These managers buy every company in a particular index, such as the FTSE 100. The only thing influencing how much the manager buys will be each company’s size. Active managers tend to levy high fees, and the evidence shows that these costs tend to offset any extra returns they could have generated.
Factor investing combines elements of both styles. A factor investor will buy and hold a wide range of companies like a passive investor. However, specific characteristics or factors will influence how much they buy. This way, factor investors aim to generate higher returns cost-effectively.
What characteristics might a factor investor target?
The explosion of academic interest in this field led to the identification of over 300 factors. However, the two “classic” factors are:
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Value: Undervalued companies tend to do better than overvalued ones based on their fundamentals. These fundamentals include the net value of the underlying company’s debts and assets.
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Size: Historically, smaller companies have done better than larger ones.
Dimensional, one of the largest factor investment managers, strongly suggests not focusing on one factor in isolation. One example is that a company might be undervalued, or smaller, because it is more likely to go out of business. Considering how profitable companies are is one way to mitigate this risk.
What about fixed interest?
Much research has looked at the drivers of return for fixed interest investments (Government Bonds, Corporate Bonds etc). The main factors identified are:
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The term, or duration, of the debt: this directly influences how sensitive the values of these investments are to rises in interest rates.
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Credit quality of issuer: the ability of the company to pay off its debt is a key consideration.
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Currency: the currency the debt is issued in can greatly affect returns.
Does everyone use factor investing?
The potential for outperformance without the high costs can make factor investing look like investing nirvana. However, it comes with risks. Chief among them is that trying to outperform a market means there will be times when you will underperform.
The outperformance factor investing generated in the 2000s led to an explosion of interest in the approach. The next decade turned out to be an awful decade for factor investing. In early 2020, for the first time in nearly forty years, the amount of money withdrawn from Dimensional’s funds was higher than what investors were putting into them. However, 2020 ended up being an excellent year for factor investing and those who had taken their money out missed out. This illustrates the need for enormous levels of patience if you solely use this strategy.
To what extent do you use it?
The defining part of our investment philosophy is that it is grounded in the evidence of what works. On paper, investing in the drivers of returns is a vital part of what has worked best over the long term. However, the evidence also shows that investors focus on short-term performance far more than long-term returns.
At a portfolio level, we acknowledge this by blending factor investments with purely passive ones so that there will always be an element of the portfolio performing as intended. We do this globally, so every equity and fixed interest market across the world forms part of our portfolios. Global diversification lowers the chance of an underperforming factor in a particular market overly affecting the portfolio.
A robust financial plan sitting above any portfolio strategy is crucial. When underperformance hits, linking the portfolio to the plan is a powerful way to address short-term anxiety.
