What is Factor Investing?

Factor investing is a hot topic among the folks in the business of designing better investment mousetraps.

So rather than focus on individual stock picking, this approach recommends that you invest in an index that’s weighted towards all specific characteristics (“factors”) shared by groups of stocks that make them more likely to beat the market

These include factors such as momentum and value.

By doing so, factor investing combines the low costs and simplicity of indexing with the additional possibility of “beating the market.”

Researchers have at looked dozens of factors that appear to outperform the mainstream, broader market-weighted indexes. A handful have proven to be meaningful.

These findings have also been responsible for the launch of dozens of factor-based exchange-traded funds (ETFs) in the last five years or so.

1. Value

Value investing has a long and storied tradition in investing, going back to the legendary Ben Graham. As outlined in his classic work “Security Analysis,” measures such as the price-to-book ratio (the firm’s share price divided by the value of its assets minus its liabilities) and the price-earnings ratio are the most basic ways for measuring value. Stocks with low valuations have tended to beat those with high valuations over time.

In the United States, the cheapest 30% of large- and mid-cap stocks (based on price/book) have outpaced the most expensive 30% by approximately 2.5% annualized from 1927 through May 2015, according to data cited by Morningstar.

From its inception in March 2006 through May 2015, Guggenheim S&P 500 Pure Value ETF (RPV) outpaced the market-cap-weighted S&P 500 Value Index, which tracks the cheaper half of the S&P 500, by 2.8% each year. Morningstar ranks it as a five-star fund. It is down 7.79% year to date.

2. Size

The small-cap effect — the tendency for smaller stocks to outperform large-cap stocks — is also a well-known tenet of modern finance. As such, it has been studied by academics and practitioners alike for decades. The higher performance of small caps comes at the cost of higher volatility.

Overall superior performance may be due to exceptional returns from a few outliers rather than from smaller companies as a whole. And small caps can underperform broader markets for years at a time.

But if you’re looking for better performance over the long term, small-cap stocks are the way to go. Invest in small caps by, say, ranking them by revenues, and you have the basis for some impressive outperformance.

RevenueShares Small Cap Index (RWJ) is comprised of the same securities as the S&P Small Cap 600 but weights the stocks according to top-line revenue instead of market capitalization. Morningstar ranks it a four-star fund. It is down 4.80% year to date.

3. Momentum

Momentum investing is a dirty word for fundamental investors schooled in Ben Graham’s number-crunching culture of fundamental analysis. Somehow it reeks of short-termism and superficiality of technical analysis. It also seems to question the validity of the efficient market hypothesis.

That may well be true.

But in the short run, recent performance tends to persist. Winners over the past six to 12 months tend to continue to outperform over the course of the next several months, while those that have underperformed often continue to lag.

And the momentum effect hasn’t gone away even though it was first published in academic literature in 1993. Momentum’s outperformance in 2015 is particularly impressive.

iShares MSCI USA Momentum Factor (MTUM) tracks the MSCI USA Momentum Index and consists of stocks exhibiting relatively higher momentum characteristics than the traditional market-capitalization-weighted parent index, the MSCI USA Index. It is up 5.61% year to date.

4. Low volatility

Perhaps the most puzzling among the major factors behind outperformance is the claim that stocks with less volatile share prices seem to deliver higher long-term returns than more volatile ones.

This flies in the face of both accepted finance theory and common sense — that more volatile (risky) stocks should deliver higher returns.

Still, the analysts and academics have confirmed that the effect is real and applies in markets around the world.

This has yet to be confirmed in practice, however, as low-volatility ETFs in the U.S. market have yet to exhibit much of any kind of outperformance versus the S&P 500.

iShares MSCI USA Minimum Volatility (USMV) seeks the investment results of an index composed of U.S. equities that, in the aggregate, have lower volatility characteristics relative to the broader U.S. equity market. It is up 2.79% year to date.

5. Quality

Perhaps the least surprising of these factors is that “high-quality” stocks seem to do better than lower-quality ones. Quality is measured by factors such as low levels of debt, stability of earnings and high returns on equity. Strong competitive advantages make these firms slightly less sensitive to the business cycle than lower-quality firms.

In a recent study, “Quality Minus Junk,” Cliff Asness of AQR found that stocks with high and growing profitability, high payout rates and low market volatility and fundamental risk historically outperformed their less-advantaged counterparts.

High-quality stocks have, indeed, outperformed the S&P 500 over the past five years, if only slightly. And it may be even more surprising that they have outperformed the ultimate high-quality stock investors’ vehicle, Berkshire Hathaway (BRK-B), by close to 2 to 1.

iShares MSCI USA Quality Factor (QUAL) seeks to track the investment results of the MSCI USA Sector Neutral Quality Index composed of U.S. large- and mid-capitalization stocks with quality characteristics as identified through certain fundamental metrics. It is up 2.22% year to date.

Factor Investing: A Free Lunch?

Thanks to the vagaries of the markets, not all of these strategies will outperform each and every year. As a group, some strategies may underperform for years.

But studies suggest that in the long run, stocks with these five factors have comfortably and consistently beaten the broader market and in different stock markets around the world.

So what’s the secret behind the success of factor investing?

On the one hand, higher returns may come from taking on higher risk. Studies have shown that value, momentum and size have all beaten the standard MSCI World index, but at the cost of taking on slightly more risk. Indeed, that’s also where you see the biggest outperformance.

But with other factors, that explanation doesn’t hold. Quality has delivered outstanding returns at lower volatility than the wider market. Quality companies are intuitively less risky: they are more likely to survive economic downturns. The same applies to low-volatility stocks. So lower risk should yield lower returns.

The secret may lie in the world of behavioral finance and Mr. Market’s moodswings. Investors may prefer the excitement of a new and novel story. That’s why they undervalue both quality companies and low-volatility stocks. They just seem dull.

Whatever the reason, factor investing today offers investors a reasonable chance to earn market-beating returns with little effort.

But free lunches in investing don’t last, especially as such simple strategies keep on winning.

Excess returns eventually will vanish. Investors will drive up the valuations of these stocks to the point where they can no longer outperform. But for now, the size of factor funds makes them too small to matter.

Until then, enjoy your free lunch.

In case you missed it, I encourage you to read the e-letter column from last week on the present and future outlook of the world’s top cities. I also invite you to comment in the space provided below.