I understand a lot of people would rather listen to the screeching of fingernails on a chalkboard than attend a workshop titled, “Assessing Potential Opportunities in Multi-factor Investment Strategies” — but not me. I love this stuff, so I recently joined S&P panel discussions in Chicago and Denver to speak with other advisors about this approach to investing.
OK, so what is it?
In theory, multi-factor investing is pretty straight forward — but in practice, it can be complicated, which is why I invite investors to ask me questions about it and encourage them to speak with other financial advisors, too.
First, let’s define a single “factor.” This is an identifiable attribute of any investment that affects the investment’s performance in the market. The academic research has identified hundreds of factors for equity and fixed-income markets (note that for the purposes of this post, I’m focused on equity markets) — but, as far as I’m concerned, most of those are wonky. The factors I pay closest attention to are intrinsic to the market. They can be seen clearly and analyzed over long periods of time — I’m talking decades — and across several markets, not just one.
Seven core factors for equity markets
Here are the core factors for equity markets I track — and a quick-hit definition of each:
Value — These are companies that are regarded as inexpensive in relation to other companies based on fundamental measures, such as earnings, cash flow and book value.
Momentum — These are companies whose stocks have performed best over a set period of time, such as the last 12 months, and should continue benefiting from that trend.
Size — Smaller companies’ stocks have a tendency to outperform larger companies.
Quality — These are companies with consistent earnings, sales growth and a low ratio of debt to equity.
Yield — These companies pay dividends and increase their dividends.
Low Volatility — Low-volatility stocks historically have outperformed high-volatility stocks (read more about stock volatility in Cardan’s 2018 Mid-Year Report.
Growth — Academics debate about whether and how much to focus on Growth as a factor. However, I often consider it. These are companies with earnings and sales growth that are above the average rate for the market.
Multi-factor investing is when investors use more than one of these core factors in an investment strategy. Market geeks like me analyze specific core factors to find investments with better returns, lower risk or some combination of the two. Then, we try to assemble portfolios of investments in such a way that we adjust for risk and optimize long-term performance. As if that isn’t enough, many of us actually do attempt to time the factors by using macroeconomic stats, such as GDP numbers. This analysis can shed some light on whether specific factors are benefiting from an economic cycle — and signal to investors that they need to actively manage investments and change course.
Food for thought
Sure, you could invest in companies based on just one factor — but if you do, know that single factors can underperform for years at a time, testing the mettle of most investors. Pairing multiple factors, or simply owning a broad index, typically yields more favorable results — and it is the route we take here at Cardan.
So, let’s consider an example of multi-factor investing focused on Value and Growth. Research we have conducted on small Value (meaning what’s regarded as inexpensive) and large Growth shows that when small Value outperforms, it does so on average for just under three consecutive years. When large Growth outperforms, it is for just under two years.
That analysis is the easy part. Now consider that large Growth has outperformed five of the last seven years and that small Value outperformed large Growth consecutively from 2000 through 2007. Think about the opportunity cost of being invested in the wrong factor for either of those periods. It’s like picking the wrong horse — and a wrong horse that got in the way of your retirements goals.
Which brings me to questions of timing — meaning when to buy or sell to achieve the best results for an investor. If you’re not going to subscribe to a multi-factor investment strategy or simply buy a broad index, it’s smart to have a strategy that can be flexible enough to put more or less money on a particular factor. As explained here, Growth and Value go well together. Other factors, such as Momentum, Size and Quality, also go well together because they can be rewarded in different market environments.
Multi-factor investing can be a very useful strategy for thoughtful diversification. However, as with many other ideas in the world of investing, it also can add unneeded volatility and complexity to a portfolio. Never mind how time-consuming it is for the average investor to track factors individually and in combination.
So, again, Cardan welcomes conversations about investment strategy and we hope to hear from you.
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