As individual investors have adopted indexing and index funds as the standard for evaluating investment performance, Vanguard and other industry leaders are moving on. To keep up, you need to think about investing in a new way and explore the next frontier. Read on to learn about factor-based investing and why understanding how it works versus indexing is important to you.
Investment Factors Are Not New
Investment factors were first proposed in the 1970s as an alternative to the capital asset pricing model (CAPM) used in index funds. Investment factors are quantifiable characteristics that help explain how investments behave. In the decades following their introduction, multiple factors have been identified.
Investment Factors Capture More Desired Performance
Better understanding of the drivers of investment performance allows for more systematic capture of desired investment performance, such as market premiums. Where CAPM explains 70% of investment performance, a combination of factors has been found to explain more than 90%.
Dimensional Fund Advisors (DFA) is the pioneer and leading provider of factor-based mutual funds. During the last 20 years (ending 12/31/18), 85% of their mutual funds have delivered higher returns, net of fees, than corresponding indexes. (0% of index funds beat their index.)
Factor Investing is Not Passive
Factor-based investing approaches portfolio construction differently than indexing. Where indexing is agnostic about differences in expected returns and passively tracks market returns by replicating the entire market (or submarket), factor-based portfolios target higher expected returns. These portfolios use filters to systematically exclude securities with lower risk adjusted expected performance and tilt (a percentage of market weight) to capture more of the desired factors.
While Vanguard describes its management of factor-based funds as active (my opinion – to distinguish them from their flagship index funds), DFA describes factor-based as different from both active, which relies on individual security selection and forecasts of future events, and passive, using index construction to replicate published indexes.
When writing Investing 3.0: What the Creators of Index Funds Discovered and How to Profit from It, I developed a numbering scheme, ala Silicon Valley, to distinguish among the different approaches. 1.0 refers to individual security selection and market forecasting. 2.0 refers to using index construction to replicate published indexes. 3.0 includes factor-based investing and other advances developed since the 1970s.
What investors need to know
You get what you pay for. Although the fees charged by factor-based funds are more than those charged by index funds, DFA’s factor-based funds have delivered higher rates of return, net of fees and other management costs.This may help explain why Vanguard launched their version of factor-based funds.
Factor-based investing is different from indexing. Although both employ systematic approaches to capturing market performance, factor-based investing focuses on exposure to factors while indexing replicates market capitalization weightings.
Because factor-based funds are designed to perform differently than indexes, analysis of their performance should be compared to new types benchmarks, i.e. ones that capture the performance of the targeted factors and distinguish targeted portfolio construction from manager performance.
Because factor-based funds are designed to perform differently than indexes, there will be periods when factor-based funds underperform comparable market indexes. During these periods, investors need to remain patient remembering that the risk of periodic underperformance is the cost of ultimately capturing higher returns. New benchmarks will help.
Different fund families use different criteria for factors. DFA is grounded in the Fama French multifactor model and employs a rigorous analysis for balancing implementation costs with other considerations. Vanguard uses different characteristics and draw from their roots in index construction in how they implement their strategies. These differences may lead to significantly different results. Pick one that you believe in.
Learn how to distinguish among the different factors, especially those that efficiently capture market premiums, and how to combine them in portfolios that balance investment risk or work with a professional advisor who does.
If you have questions about how to enter this new frontier of investing, contact me. I will be happy to provide a complimentary review.
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