First let’s consider the various investment options available to us. At one extreme we have passive index funds, which have low fees and track the performance of indices like the S&P 500 and MSCI World.
At the other extreme you could invest in an active fund, where individual stocks are chosen with the aim of outperforming their benchmark (typically the most appropriate index, e.g. MSCI World Index if selecting stocks globally). These have higher fees and can have larger swings in performance. In fact, the vast majority of the time, 87.98% (Source: S&P Global, as of Dec 31st 2023), these funds underperform their respective benchmarks.
Factor investing sits in between, but what is a factor I hear you ask… well, a factor is a characteristic that can help explain why certain groups of securities may perform the way they do in terms of risk and return.
The following are examples of factors; value (for under-valued companies), size (companies with smaller market capitalisations) and quality (companies with strong profitability, stable earnings etc.).
Academic research (notably Fama-French) shows that these characteristics explain significant amounts of stock performance over time. One can use factors to seek better risk-adjusted returns than simply following an index or trying to hand-pick stocks.
We find analogies often help, so let’s imagine we’re purchasing a car….
- The passive approach would be to buy the standard model, which will be cost-efficient and gets us from point A to B.
- The active approach would be to heavily modify the car, swapping out most of the parts. Whilst we may get a faster car, it could be more dangerous or we may significantly impact the reliability and long term durability.
- The factor-based approach would be to add a few key upgrades which will most improve the car. We could invest in better tyres, fuel and brakes to enhance our mileage and safety, without sacrificing reliability.