Factor | noun | fak·ter | A characteristic or element that contributes to a result or outcome.
Forty years ago Vanguard founder, Jack Bogle, created and launched the world's first index mutual fund (the Vanguard 500 Index Fund). This fund, and the many index funds created since, have provided an overwhelming benefit to investors and have recently picked up, even more, momentum. According to Bloomberg, since 2011 index funds have seen $1.7 trillion of inflows compared to $5.6 billion of outflows from actively managed funds.
But, while there are many benefits to index funds, the question is, can they be improved upon? The answer appears to be “yes” as academic research has revealed a few characteristics, or factors, of individual stocks that have led to increased returns compared to a simple market cap weighted index.
We will explore these factors, but first, let's look at the advantages of index funds (the benefits we want to preserve), define what we mean by factors, and see how indexes treat these factors.
Advantages of Index Funds
When building portfolios for clients, we rely heavily on index funds because of their numerous benefits: low expense ratios, minimal turnover which saves on trading costs and taxes, and diversification across companies, sectors and countries.
Recently, to highlight this last benefit, we showed the following chart to a client. According to JP Morgan, two-thirds of all individual stocks returned less than the Russell 3000 index over the 1980-2014 period, and 40% of all stocks had a negative absolute return. Most people think picking individual stocks is a coin flip when in reality the odds are stacked against you. Instead of a 50-50 chance of beating the index, it's more like one in three. Given these long odds, diversification is needed to ensure you don't miss out on the “extreme winners” on the right side of the chart.
Another study, this one by Longboard Asset Management, showed the best 25% of all stocks accounted for all the gains on the Russell 3000 index over the period from 1983 to 2006. It’s dangerous, indeed, to miss out on these winners.
Source: Longboard Asset Management
These studies certainly highlight the benefits of diversification. But this perceptive client asked an interesting question: Are there different attributes to the stocks on the left versus those on the right? This brings us to factors.
What is a Factor?
A factor is simply defined as a characteristic or an element that contributes to an outcome. In the investing world, it’s defined as common attributes that lead to better (or worse) returns over time.
To use a baseball analogy, in his book Moneyball Michael Lewis highlighted the importance of “on-base percentage” to a team’s success. The Oakland A’s found on-base percentage to be an important factor of a player’s value and therefore the team’s success. The rest of the league tended to ignore on-base percentage and used the traditional metric of batting average which ignores walks. The A’s exploited this factor to the detriment of the rest of the league.
Just like on-base percentage is an important factor when building a baseball team, the academic research has revealed several factors in stocks that lead to different outcomes.
Different Companies, Different Attributes
Most index funds are designed with market-cap weighting—meaning a company's weight in an index is determined according to its market value regardless of other attributes. But, if research has revealed favorable factors we, ideally, should want more of them. This then is the drawback of index funds: the weightings of stocks with positive attributes are not increased, nor are the negative ones’ minimized.
But, if actively managed funds aren't a good way to get exposure to these attributes (research has shown time and time again that active management (i.e., stock picking) does not result in better returns over time), the question is: can one preserve the benefits of index funds while tapping into attributes of higher returns? The good news is that academic research has identified four primary factors that are persistent and pervasive, but we are left to wonder what’s a smart way to include them in a portfolio?
Now that we have an understanding of what factors are, next time we will dive deeper into the different factors identified in the research, take a look at their performance, and outline the “catch” when it comes to incorporating them into your portfolio.