Smart Thinking

Factor Investing

 

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Factor Investing has been creating quite a stir in the funds world over the past few years. Here is why and how you can take advantage.

A fascinating paper published by Frazzini, Kabiller & Pedersen of the Yale Department of Economics, in August 2012 deconstructed the investment returns of arguably the world’s most successful investor over more than half a century: Berkshire Hathaway’s CEO Warren Buffett. The authors suggested that his strategy could be broken down into a number of clearly identifiable factors. The paper concluded that Buffett’s incredibly strong returns could largely be explained by the deployment of leverage combined with a strategy that focused on stocks that demonstrated three attributes:

  •  Value, or cheapness in share price relative to their intrinsic value
  •  Volatility, or relative price stability
  •  Quality, or decent financial strength on a range of metrics

Also known as “Smart Beta”, “Alternative Beta” or “Style Investing”, Factor Investing has grown rapidly in popularity based on the idea that stocks should be chosen according to how well they meet a specific set of Factors. These in turn are believed to be linked to market-beating performance on the strength of academic study or market-based observation. We can now expand the list to six common factors that may be used to select stocks that should be capable of subsequent outperformance. In addition to the three criteria mentioned earlier, Factor Investing also looks at:

  • Size, or a focus on medium sized or smaller companies
  • Momentum, or stocks with recent, strong share price performance
  • Yield, or firms that pay above average dividends

The best of both worlds?

One of investing’s bigger ongoing debates concerns whether active investment management or passive index tracking is the better bet. Factor Investing may offer confused investors something of a win-win. It combines characteristics of both active fund management (an approach that seeks to beat the market)and passive fund management (an approach that rigidly and objectively follows a set of rules). Perhaps unsurprisingly, the running costs – management and operating fees – of Factor funds sit somewhere between those of traditional actively managed funds and conventional tracker funds. Frazzini, Kabiller & Pedersen highlighted just how powerful Factors may be at explaining investment returns. Chart 1 shows a comparison of Berkshire Hathaway’s publicly traded stock portfolio, the US stock market (adjusted for comparable leverage) and a portfolio of US stocks adjusted to reflect the same sensitivities that Berkshire Hathaway’s quoted portfolio has to the Investment Factors listed earlier (the “Buffett-Style portfolio” below).

This is an excerpt from an article published in the autumn 2016 copy of Confidant, our quarterly magazine. For access to the full article, please contact us on [email protected]