We Are All Factor Investors

Smart beta, indexing, Fama/French, margin of safety, Graham (deep) value, growth, momentum, GARP. Each of these terms represent very different styles of investing, but they all have one thing in common: they are all predicated on the fact that certain factors have, and will continue to, drive stock returns.

·         Smart Beta: fundamental-weighting, low volatility

·         Indexing: market cap (larger better), costs (lower better)

·         Fama/French: book/price (higher better), market cap (smaller better)

·         Margin of safety: business moats, cheap valuations

·         Graham Value: very cheap valuations

·         Growth: earnings growth

·         Momentum: strong price trends

·         GARP: strong earnings growth and reasonable valuations

If you think about the stock selection process, you’ll see that everyone makes decisions based on some factor(s).

How we make investing decisions

If you are an “active” manager, trying to select stocks that will outperform the market, the process is always the same, and it looks like this:

Both traditional and quantitative managers follow this same process: they collect data they believe to be relevant, process/evaluate that data, and reach conclusions. They buy certain stocks based on certain factor inputs.

Each approach has one major weakness (and many other small ones).

Quantitative Weakness: The quantitative approach is reliant on data that tends to be fairly raw. This means that its weakness lies in its lack of nuance. Raw reported data will sometimes be wrong or hide important realities (think off balance sheet items on bank balance sheets in 2008).  I don’t mean to plant the axiom that traditional managers all do pick up on these inaccuracies/nuances, but some do and have been successful as a result.

Traditional Weakness: Any good strategy only works if it is consistently applied over long periods in the market, but human beings are extremely inconsistent thinkers. This means that relative to quantitative managers, it is very hard for traditional managers to measure and apply their preferred factors across a large universe of stocks, and to do so consistently through time.

One of the reasons that indexing works is that it is so consistent. Its strategy (buy big stocks, the bigger the better) is mediocre, but it never veers off course. Most humans are extremely inconsistent in their decision making and processing of information. Losing $100, for example, has twice the emotional impact on the average human than does gaining the same $100 dollars: we are wired to be especially sensitive to losses.

You can see this tendency in the following chart of all U.S. stock market bull/bear markets. The bulls tend to be slow & plodding, often lasting many years. The bears, by contrast, tend to be sharp, quick and painful.  They are fueled by panic: our oversensitivity to losses.

Humans are a lollapalooza of behavioral biases, and these biases precipitate bad decisions.  Because we aren’t well wired to make smart and consistent investing decisions, I believe that the quantitative approach is superior despite its weaknesses; it removes emotional influences from the investing process. If you believe in factor investing over index investing, then the quantitative approach is more reliable.

Factor Investing in the Future

The funny thing about factors is that just like individual stocks themselves, a factor’s short term success will likely be inversely related to its popularity among investors (which will, of course, wax and wane). Measuring a stocks popularity is pretty easy: lofty valuations, large returns over the past few years, and very high share turnover can all help you identify the most popular stocks (and as I’ve written here and here, they tend to perform terribly). But identifying popular factors is more difficult.  We can look at factor spreads (e.g. how much cheaper are the cheapest stocks than the most expensive stocks) and conclude that the narrower the spread—and therefore the more similar stocks look—the more popular the factor. We can also look, more subjectively, at how often certain factors are mentioned and what sort of fund flows they are garnering (think of the large inflows into dividend yield in 2012, which went on to underperform in 2013). These are imperfect, though, so timing factors will be difficult.

Investing is an incredibly complex endeavor, so it is impossible to sum it up…but J.M. Keynes came close when he said, “It is largely the fluctuations which throw up the bargains and the uncertainty due to fluctuations which prevents other people from taking advantage of them.” So long as people (compelled by human nature) are responsible for pricing stocks, one edge will likely persist: that which is out of favor—be it a stock, industry, country, or a factor—will likely outperform.  It is psychologically difficult to do, but if you want to beat the global market index funds, you’ll have to position yourself in parts of the market that others disdain. Picking factors in the short term will be as difficult as picking stocks in the short term. I think the key is to instead focus on the longer term: do your own investigating, find what factors make sense to you, and stick with them through thick and thin.