The Truth About Factor Investing!

April 3, 2023

In this highlight, Brian and Bo discuss everything you need to know about factor investing and if you should be using this strategy.

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Let me share some of these common strategies you might see out there on TikTok, Instagram, or other places so that you can actually know how this fits into your portfolio and your investment philosophy. What we’ve done is we’ve tried to go grab some of the most popular ones, and the first one we’re going to talk about is one that, if you are in investing circles and if you’ve been investing for a while, you’ve likely come across. It’s this idea of factor investing.

Now, factor investing is just a process of choosing investments based on specific factors that are believed to be associated with higher returns, such as smaller stocks or those that are undervalued when you look at the P/E ratio. Here are some common factors that people think about: company size, growth, valuation, profitability, historical performance, leverage, liquidity, and momentum. It makes me think about Brian. I’m not like a huge sports fan, but you know, I’ve got those buddies that like they’re all into recruiting and they’re all and they’re like, they will look at specific attributes. Oh, this guy, man, he’s got an arm, and it’s a cannon, or this guy, he can shoot threes. It’s kind of like selecting your investments with that, what’s the special thing that this holding can do that, because they can do that, it’s going to outperform long term because there’s some unique trait about it. It’s going to be a factor that’s going to lead to better performance, and I think a lot of people are thinking of looking into that super deeply.

Well, I’ve got to think, because you laid out like fantasy football, you laid out sports and other things, surely there’s more to this than just the gut feeling that this month we’re going to focus on momentum or this month we’re going to focus on liquidity just because the banks are struggling. There’s research and there are other things that have gone into this. Can you give us a little deeper dive on that?

Yeah, so factor investing is popular because we go through economic cycles where different types of assets perform better than others. Here’s a really easy example. If you look at the last 12 years and you’re just looking at US large cap companies, and you picked growth as a specific factor, you’re going to utilize US growth companies. US large cap US growth has outperformed large-cap US value to the extent of 400 percent relative to about 265 percent. So if that were a factor that you had honed in on for the last 12 years, you would have outperformed. You would have been pretty happy about that. But you can see pretty clearly if you were someone who thought value was going to be the factor that you should lay onto, maybe you would not be quite as happy as those growth investors.

But the question I have is because I see this, and we see large-cap growth value. I know also the data started here in 2010. We came out of the Great Recession before this where we had the boom, and obviously, so much has gone into innovation, and we’ll talk about that when we delve into dividend investing and so forth. But I know that people, when they’re talking about factor investing, it’s not typically just large-cap growth versus value. There’s actually a model, and I like to say FF3. And we’re not talking about Fast and Furious Tokyo Drift. What is FF3?

So, there were two University of Chicago professors, Eugene Fama and Kenneth French, that developed the Fama French three-factor model. What they did is, using specific research that they had conducted back in 1992, they found that if you could look at company size and historical performance, and then book to market valuation, and just focus on those three factors, you would be likely to pick out-performers moving forward. So, according to the famous French model, you look for smaller companies that were undervalued, which means lower price to earnings ratios that historically had outperformed the market. There was some momentum behind these companies. And while that sounds great, if you actually look at this, let’s play this out practically. If you’re looking at small companies with low P/E that historically outperformed, you guys have seen this illustration a lot, this is the Cal and Periodic Table of returns. It shows a number of different asset classes, and they’re all color-coded, and this shows the last 20 years from 2003 all the way till 2022 and how each of those asset classes performed relatively, so you can kind of see how the colors bounce around. Well, if you were to implement this Fama French Three-Factor model, you would have had the green line performance, and what you can see is it’s kind of like an EKG, it’s way up and way way down, and there are some years where those specific types of companies were really strong performers, but there are other years where maybe they didn’t perform as strong. It’s a pretty volatile ride. When you lay over that just the broad market, just looking at U.S large-cap equity, the boring market that we think of, the S&P 500, you can see that from a trend standpoint, it kind of moves in the same direction, but it’s much more compact. The yo-yo string isn’t as long. And so the question becomes if you just implemented this Fama French Three-Factor model over the last 20 years, would you have been better off because of it? Would the factors they pinpointed have been the ones that actually caused the outperformance? And it’s really interesting. U.S small-cap stocks over that time period performed about 9.4 percent on an annualized basis. U.S large-cap performed 9.8 percent. So the large-cap market is the boring old market that actually outperformed. What I think is wild is for most investors, that ride would have felt so much smoother from a psychological standpoint. You wouldn’t have had these wild ups and downs like you did in the small-cap portfolio.

So we’ll get to this a little bit later when we talk about the Money Guy flavor on how you actually bring this into your investment philosophy. But what I find interesting is that when people go all-in and they say factor investing, I look at a chart like this, and I think of modern portfolio theory where I don’t want it to be an either-or. I actually like both of these. I like small-cap investments in my portfolio. I like large-cap investments. Why don’t we do both instead of either-or? And that’s something that’s very interesting. But I love the thought that when academics and researchers and others get together and they are trying to come up with a better mousetrap, I’ll just be curious to see if this is the way you should actually implement your investments. So, if I’m someone out there listening, and I’m hearing this, I’m probably asking the question, “Well, why do people do this? Why do people do factor investing?

If there are these really smart professors who say, “This is the way,” why don’t people do that? Well, it’s kind of in line with what you just said. Not all factors or segments of the market offer the same risk-adjusted rate of return. If I pull off the chart, if I pull off the lines and I just share this chart again, and you just kind of zoom out, you probably can’t really read it. But if you look, it’s not uncommon for some segments to be top performers and maybe even top performers for a number of years. But then you find that in the very next period or the very next group of years, they’re under performers. The one that I like to point to is kind of like that yellow/orange emerging markets. There are seasons where if that’s the factor that you’re honing in on, you’re going to feel like you’re a genius, you’ve got it all figured out. But then there are seasons where that’s the factor that you’re trying to hone in on. You’re going to be like, “What in the world did I do? Holy cow, how could I have been so wrong?” And you said it best, Brian. I don’t think that when it comes to factor investing, I don’t think it’s an either/or. I think it’s a both/and in terms of how we do factor. I don’t want people to be reactive with their investments. It’s just like right now we know there’s turmoil in the banking sector. So, you heard us say one of the things you could focus your Factor investing on is liquidity. So, a lot of people might be thinking, “Hey, let’s go ahead and run a screen where we pull out any type of things that struggle with liquidity, cash, and other things because I want to protect myself from any type of volatility of that.” Well, the problem with any of these plays is if you’re especially if you’re reacting to the current events of the financial world, you might be missing out on because the opportunity of a lifetime because a lot of times people, the maximum market opportunity to invest in something is when everybody else hates it, when they’re running for the exit. I mean, that’s the part that I get nervous about is because you look at in the past like with the Great Recession if you ran a screen to make sure you excluded different sectors like the financial sector after the Great Recession or maybe after the dot com boom if you ran a screen to exclude technology from this, you might be getting yourself in a pickle in the long term because some of those components that seem desirable at the are least desirable at the time might turn out to be your best performers over the 10 to 15-year long-term window. And that’s just something that I once again, I’m not a load up on one strategy. I’m more of a diversifier. And so what’s our flavor when we think about Factor investing? Well, Factor investing in the academic sense relies upon upon the belief that future performance of a stock or of a holding can be determined by historical quantifiable factors. Well, we all know if you’ve ever watched anything investment-related, there’s always this disclaimer, “past performance is not indicative of future performance.” I just don’t know that it works so cleanly. Just because something was the top performer yesterday does not mean that it’s going to be the top performer tomorrow. And so when you really boil down into those that are like true-blue Factor investors like they are picking factors and betting the farm on it, it’s really technically a form of active investing. Yeah, and you see people run concentration strategies and so forth.

I always get nervous because I’ve told you guys I believe in the great big beautiful tomorrow and the law of accelerating returns and innovation and disruption. There are always going to be ways for you to invest and take advantage of this ever-expanding economy. That’s not just based on a feel-good feeling that the world’s getting better, and I’m a natural optimist. It’s also because when you look at the performance of large-cap investments over the last 10 years, 93.1% of active managers underperformed just buying the index. There are a lot of calories being spent, a lot of energy trying to figure out the next big mousetrap to get ahead of the curve and everybody else. What I’m telling you guys is we live in the greatest time with the greatest innovation. Just buy the market, and you’ll be rewarded for it.

Yeah, I think you said it perfectly. Factor investing, in our opinion, is not so much an investment strategy as it is a portfolio design tool. When we design portfolios, we’re all trying to think about what factors we want to utilize. Are we going to invest in large companies or small companies, and how much are we going to do that? Are we going to invest domestically or internationally, and how do we decide how to split that up? The real gripe we have with factor investing, and specifically those folks who are out there touting it so strongly, is how granular you get with the factors. Like, “I’m just going to invest in this very specific set of companies.” How hard do you really bet the farm on any one factor because you feel like you have it figured out? And how confident are you that the factor you have uncovered is the one that will deliver future performance? Because what’s really, really frightening is that statistics and numbers and graphs and charts can be a little misleading. If you don’t believe us, look at this chart right here.

This chart shows an overlay of the consumption of margarine from the year 2000 to the year 2009 and the divorce rate in Maine. What you would be able to conclude from this illustration is that, so long as less margarine is being consumed, people in Maine will be getting divorced less. Just because something is correlated, just because something can move in tandem, doesn’t mean that there’s causation associated with that. So just because you uncover some factor that did perform well or two factors that are related that performed well and were highly correlated, does not mean that one caused the other. People can arrive at very misleading conclusions when it comes to factor investing.

Yeah, I just want you to be open to expanding your toolbox to where you’re not just a hammer looking for a nail. You will consider using large-cap, you will consider using small-cap. You will actually broaden beyond just where the factors that at the moment might be yielding good results, but over the long term, are probably going to moderate and revert to the mean, as we like to talk about. So don’t get caught up in those trends, the hypes, or other things when it just might not be saying that factor investing is wrong, but it’s probably just one component of a much bigger thing that you’re doing with your investments and your asset allocation.

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