Factor investing is nothing new as various index managers such as S&P and MSCI have been providing data for a variety of factor indices for more than 20 years now.  However, along with the rise of ETFs that have made it easier, factor investing has risen in popularity over the last few years.  For the uninitiated, factor investing is basically investing in a portfolio of stocks that are grouped together based on certain shared characteristics that have demonstrated some level of excess performance historically.  There are many factor-based indices (and funds that track them), but the average reader will likely be more familiar with some of the more popular factor-based indices, such as “low-vol,” which is composed of stocks that have exhibited less volatility than the markets overall, and high-dividend yield, which is a portfolio of stocks with a history of healthy and rising payouts to shareholders.

That being said, Josh Brown of Ritholtz Wealth and CNBC posted a link to a ‘factor quilt’ created by ETF Trends that shows that, from one year to the next, the top-performing factor-based portfolio can just as easily be the worst performer the next year, as was the case with high-beta from 2010-2011, and with low-volatility from 2011-2012:

Equal-Weighting Factor Bets

Factor Bets

(Note:  The factor indices shown are the S&P 500 Momentum TR, S&P 500 Low Volatility TR, S&P 500 TR, S&P 500 High Beta TR, S&P 500 Dividend Aristocrats TR, S&P 500 Value TR, and Russell 1000 Quality Factor TR)

As my friend, Jake, from EconomPic Data, noted in his related post on dynamic factor investing, the key takeaway from the ‘factor quilt’ and the ETF Trends article (authored by John Lunt) is that most investors will likely abandon an underperforming factor bet, and run the risk of missing out when it returns to lead the pack, as was the case with high beta from 2005-2008 when it was at the bottom, only to be the top performer in four of the next five years.

(Note:  Jake addresses this problem in his post with a very creative dynamic asset allocation model.)

The problem, of course, with factor investing, is that factor under- or overperformance (relative to the S&P 500) does not happen in a vacuum.  There are external factors at play that investors must get right in order to reap the benefits of the more focused strategy that factor investing really is.

For example, there has been a heavy correlation between movements in the US dollar and the relative performance of the S&P 500 Value index:

Equal-Weighting Factor Bets

Why this is the case should not be surprising; the S&P 500 Value Index has a much higher weighting in dollar-sensitive industries such as energy and materials, so when the dollar is weak, those industries have tended to outperform the market, thus propelling the Value index ahead of indices that underweight those industries, or exclude them altogether.

Similarly, the Dividend Aristocrat index has seemingly benefited from the plunge in bond yields over the last decade.  This can easily be seen by showing the relative performance of the S&P 500 (price return only) versus the Dividend Aristocrat index (also price return only) against Treasury bond yields.  The further bond yields kept falling, the greater the relative underperformance of the overall market versus higher-yielding stocks, presumably as investors bought them as bond proxies:

Equal-Weighting Factor Bets

So, now that we have identified a few potential reasons why certain factor bets can outperform the market over a given period of time, the problem remains:  how can a factor investor give him or herself the best chance of succeeding at factor investing?

I believe one potential solution would be simply to equal-weight the various factor bets, and rebalance annually.  I have created just this hypothetical portfolio of the above-referenced indices, and the results were what you might guess:  in the middle of the pack as far as returns, volatility, and drawdowns are concerned, but better than the overall market’s performance, which is the alleged purpose of factor investing anyway:

Equal-Weighting Factor Bets

Here is a table of the results:

Equal-Weighting Factor Bets

Again, it is extremely unlikely that an individual investor will guess correctly the direction of the dollar, Treasury bond yields, or whatever external variable leads to a given factor bet’s outperformance, so perhaps the simplest solution — and perhaps the one that gives the factor investor the best chance to succeed — is to diversify across factor bets and to maintain the discipline to rebalance among them.

Disclosure:  The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index.

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Fortune Financial Advisors, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Fortune Financial Advisors, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

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