How To Approach Factor Investing

September 25, 2017

[Editors Note: If you’re interested in smart-beta and factor Investing, check out our upcoming webinar series that kicks off this Friday on understanding and using factor strategies. Register here.]

The proliferation of quant-finance-based ETF strategies has definitely left investors with a lot of options.

Back when I started in the business, Wells Fargo Nikko Investment Advisors (which became BGI, then BlackRock, through acquisitions), used to sell a very popular strategy to institutions called “Tilts & Timing” which, if launched today, would simply be another “smart-beta ETF.” That was in 1992.

The question for investors is not whether a factor-based approach to investing can work—of course it can. The challenge is in predicting which factors are going to be in or out of favor in a given market environment, and increasingly, understanding what your exposures even are, relative to a more common vanilla alternative.

Is Timing Everything?

One of the age-old questions most investors are aware of is the growth-versus-value conundrum. Over the long haul (the very long haul), investing in the value factor seems like just the easiest call ever, as does skewing your portfolio away from large-caps.

As Larry Swedroe and Andy Berkin point out in their excellent book on factor investing, the odds of underperforming the market in any random 20-year period by being invested in small-caps from 1927 to 2015 was just 14%. And if you invested in value, the chance of getting it wrong drops to 6%.

And yet, if you really get it wrong, the market can crush you for a very long time indeed:

 

Small-Cap Value Drawdowns

Time Period No. of
Months
Cumulative
Underperformance
During the Period (%)
Cumulative
Performance
in Post-
Period (%)
Jan 1929 - June 1932 42 -8.9 230.6
Nov 1971 - Dec 1973 26 -19.0 67.1
July 1989 - Aug 1991 26 -27.5 44.5

 

 

So how do you know when it’s time for what? Well, the simplest and most naive way is to simply look at charts.

For instance, you might look at the historical relationship between growth and value right now (proxied here by the iShares S&P 500 Growth (IVW) and the iShares S&P 500 Value ETF (IVE) below):

 

 

If you believed that, over time, these two indexes should revert to the mean, you might look at the recent run in growth and think, “Well, value is due for a comeback; just look at this year!”

 

 

Or, alternatively, you could think, “Wow, growth is running; time to pile in!”

I’d argue that both of these are somewhat woolly-headed approaches to investing, but I’ve met countless investors who use language like “due” and “running” to make short-term decisions. For factors, however, that kind of short-termism is a bad approach to take.

 

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