Factor investing, which revolves around an investment according to specific, pre-determined characteristics (“factors”), has piqued the interest of many in the investing world as investors hope they can finally beat the market on a consistent basis. According to MSCI.com, indexes can be constructed according to these six risk factors: Value, Low Size, Low Volatility, High Yield, Quality and Momentum. By doing so, factor investing combines simplicity, transparency, and the affordability of indexing with the irresistible prospect of “beating the market,” which explains its surge in popularity over recent years.
By attempting to generate alpha this way, it is not difficult to see the appeal for such instruments, especially given the fact that stocks boasting more than one of these six factors have fared relatively well over the long-term. However, investors should be wary of jumping into factor investing head-on, especially given its rapid increase in popularity. While in theory returns offered by factor-based investments should be greater than those that are not, increasing popularity has the ability to drive up valuations considerably.
Factor investing is the latest trend to sweep through the investing universe and should be handled with a healthy dose of skepticism. Much like the tech obsession of the late 90s and the real estate craze of the 2000’s, factor investing is perceived to be impervious to market cycles. Yet as history dictates, supposedly “perfect” investments are eventually rendered imperfect by higher valuations and excessive supply. Still, there is no denying that such investments produce considerable short-term gains that appeal to the nearsightedness of most investors. That said, it is of paramount importance that investors do not mistake short-term gains for suitable long-term strategies.
Every investor wants to be invested in the best performing asset class every year. The problem is, few investors are lucky enough to consistently choose the right asset class to invest in. Furthermore, fads are subject to extreme volatility on a year-to-year basis. Commodities, for example, were all the rage in 2007, posting a solid return collectively. Yet in 2008, commodities posted a dismal loss, wiping out the prior year’s gains and then some. According to MFS Investment Management, a well-managed diversified portfolio did not just post positive returns for 18 of the past 20 years, but also performed competitively over the 20-year period. Over-exposure to new flavors will almost certainly result in poor diversification and/or disappointing returns when weighed against the performance of a properly managed, well-diversified portfolio.
Ultimately, investors should keep in mind sound investing principles when deciding on which securities to include in their portfolio. Diversification, a long-term strategy, and the discipline to follow evidence-based strategies are relatively boring pieces of investment advice that most people tend to ignore. However, such dull advice is often the best advice for achieving long-term growth.
That does not mean a well-managed diversified portfolio cannot include factor-based investments; the problem, however, arises when the portfolio is disproportionately skewed towards something like one of these relatively new investment vehicles. In order to properly position themselves for optimal growth with commensurate risk, investors need to be able to invest in various instruments without overexposing themselves to any one investment style.
The moral of the story is this: By all means, explore, dig up various types of “perfect” investments – just be sure not to get carried away and stray too far from the free lunch of diversification, which has proven its case time and again for long-term investors.