Does it require unusual intelligence to succeed as an investor? Not really. All the evidence suggests the opposite may be closer to the truth.
Most actively managed mutual funds can’t keep up with low-cost index funds that blindly track the market. Most hedge funds and many university endowments also lag a simple index-based approach.
The past five years have been a particularly bumpy time for the intellectual elite of the financial profession. During this patch, many of the clever data-backed strategies developed by financial researchers to trounce the market have produced only so-so results.
What should we make of this? To my eye, it suggests that true intelligence lies in managing your expectations – particularly when it comes to understanding what investing research can and can’t do for you.
Let us start with what it can do. Leading academics recognized as early as the 1970s that traditional stock-picking fizzles when it comes to reliably beating the market. Those early researchers showed that choosing individual stocks is a mug’s game for most investors.
The academics also pointed toward an elegant solution: the index fund. Buying an index fund is a smart strategy because financial markets are surprisingly efficient at amassing all the relevant public information about companies, then using that info to price the companies’ stocks and other securities.
While there can be periodic bubbles and crashes, shares are typically valued at levels close to what they’re realistically worth. As a result, index funds that simply buy and hold a broad swath of the market tend to do better on average than actively managed funds that run up significant expenses in attempting to identify the next big thing.
The growing recognition of these facts has spurred a widespread turn toward low-cost index investing. After all, if you can’t count on doing better than the market, why not simply capture whatever return the market generates at the cheapest possible cost?
Oddly, though, the growing evidence of market efficiency has also encouraged a move in the opposite direction. Researchers at leading universities and money managers have devoted huge amounts of effort in recent years to seeking ever more ingenious ways to potentially beat the market. In particular, they have laboured to identify “factors,” or characteristics, that can help predict which groups of stocks might perform best over the long haul.
The list of possible factors keeps on swelling. For now, the most popular ones include value (bargain-priced stocks), momentum (fast-rising stocks), low volatility (stable stocks) and quality (stocks with low debt and high and stable earnings).
Fund companies have been quick to pounce on this research. CI Financial, iShares and Vanguard are among the vendors now offering factor-based exchange-traded funds (ETFs).
What’s not clear, though, is whether factor investing actually delivers results that beat a simple index fund. It all depends on which period you look at.
During the 23-year stretch between 2000 and now, betting on just about any popular factor would have worked out splendidly, according to research by Ian de Verteuil, head of portfolio strategy at CIBC World Markets. Whether you had chosen a value approach (which delivered annual returns of 13.9 per cent a year over this period) or a low-volatility strategy (13.2 per cent) or a momentum scheme (14.5 per cent) would not have mattered. All those factors – as well as others such as size, growth and quality – produced substantially better results than the S&P/TSX Composite (10.2 per cent).
Look at the past five years, though, and the picture changes. During that patch, only the value factor has managed to do better than the market and its results are only a whisker better than the simple index.
Is factor investing broken? Some people think so. The ability of factor strategies to beat the market appears to be declining, not just in Canada, but elsewhere.
Jay Rajamony, head of alternatives at money manager Man Numeric in Boston, argues that all the popular factors are in decay, largely because so much money has crowded into bets on them that their performance is eroding. Other critics blame poorly designed factor-based products for the disappointing recent results.
A more hopeful explanation is that we are simply going through a rough patch. Even factor advocates acknowledge that individual factors can suffer through long periods where their performance falters. In the British market, for instance, momentum fizzled for 26 years from 1965 to 1990, according to Credit Suisse researchers. In the U.S. market, value disappointed for 37 years from 1984 to 2020.
So what should a reasonable investor do now? The long-term results from factor investing are too impressive to ignore. Even if they haven’t beat the market recently, most factor-based strategies are still producing healthy returns.
But the unpredictability of factor investing suggest investors should be cautious. As smart as these strategies may be, they don’t guarantee great results in the short term. If you’re thinking of taking a factor-based approach, you may want to consider diversifying among two or three different factors. You may also want to remind yourself that being smart can require a long time to pay off.
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Ian McGugan