Academic research from the 1970s has been helping nudge investment portfolio returns upwards ever since. By focusing on certain, specific characteristics – or factor tilts – a wealth manager can make their client’s portfolios slightly more resilient in bad periods and perform slightly better than average in good periods. This is widespread now – see, for example, the $25.4 trillion AUM figure.
Here, we explain how it works and why it matters to your money.
Stephen A. Ross, the author of this 1970s research, was in many ways unremarkably brilliant…
Born in 1944, Ross studied at Caltech and Harvard. He held senior positions at MIT, Yale and other elite institutions[i]. He followed a well-worn path for the gifted. But then he wrote a paper that completely changed the way people think about managing money.
His ideas are probably working away in the background of your investment portfolio, making it a bit more durable, a bit hungrier for additional returns.
Stephen A. Ross invented factor investing.
In the beginning
Ross’s paper is almost comically complex. The Greek algebraic symbols start in paragraph one and keep going for 18 pages.
But his “Arbitrage theory of capital asset pricing” boils down to a simple, intuitive idea:
- investments that display historically higher-than-average returns have a range of factors in common; therefore
- seeking out these factors can give a portfolio access to these higher returns[ii].
Since that 1976 paper, the investment industry has embraced and refined these ideas. Today, if you want to gain access to the factors that demonstrably generate higher returns, you have a wide range of choices. You’ve got macroeconomic factors, like inflation or the unemployment rate, which are linked to returns across whole asset classes – such as shares or bonds. Style factors, like value or size, can give you returns at a more precise level – namely individual companies.
We find style factors are most easily fitted into our evidence-based approach for clients. They can keep costs low while nudging long-term returns upwards.
Never mind the width, feel the quality of factor tilts
There are five style factors:
- Value means looking for companies that the market is pricing at a discount to their fundamental value. In other words, if analysis shows a company is worth more than its current share price, it is good value.
- Size refers to the fact that smaller companies often do better than larger ones. This means seeking companies with a comparatively low market capitalisation – namely the price of a single share multiplied by the total number of shares.
- Momentum is, as you might expect, the factor that shares which have done well in the past often continue to do so in future.
- Quality means a company with relatively consistent growth, low levels of debt, and which is well governed.
- Volatility, or the rate at which a share price rises and falls, affects long-term investment returns. Lower volatility shares tend to do better than higher volatility ones.
We favour the first two – value and size – because they can be simpler to implement and can have the greatest impact.
Factor tilts in your portfolio
When invest each client’s money, we try to balance two ‘knowns’.
On the one hand, we know that passive investing is more effective than active investing[iii]. In other words, a ‘star’ fund manager, who tries to beat the market, may burn brightly for a short period but will never eclipse the remorseless, superior growth of the market over the long run. The latter approach is also more cost-effective.
On the other hand, factors like value and size can help a portfolio do a little bit better than ‘the market’.
So we make a reasonable compromise.
For example, let’s say you’re risk averse. We’d look at your assets and your objectives and we might put none of your money into factor funds. If you have a medium attitude to risk, we’d use factor tilts in your portfolio, tilting investments slightly towards the big factors. This could mean four in every five pounds would be in passive funds, the rest in “factor tilted” funds to give the overall portfolio an appropriate boost. If we agree you have appetite for higher levels of risk (and their bedfellow, higher returns) we might go for a bigger tilt towards factor funds – perhaps as much as a 2:1 split, between passive and factor.
The idea is to create something that meets your financial and emotional needs based on what you have, where you want to get to, and how you’d like to travel there.
It means you don’t need to keep checking your portfolio (that’s what we’re for) – plus you’ve got the assurance that your money is standing on the shoulders of academic giants.
Like all sensible compromises, there are trade-offs. A factor tilt will probably underperform the market for a short period. For example, stock markets frequently switch between favouring ‘growth’ and ‘value’ investors – and the latter approach can look anaemic for a time[iv].
But if you use a range of factors, in appropriately sized doses, they can combine to insulate some of your money when stock markets go down.
In any case, it’s the long-term we’re interested in. And, with almost 50 years of evidence behind it, a factor tilt could help position you and your money advantageously.
[i] https://en.wikipedia.org/wiki/Stephen_Ross_(economist) rel=”nofollow”
[ii] See for example the summary at https://corporatefinanceinstitute.com/resources/wealth-management/arbitrage-pricing-theory-apt/
[iii] There is a vast amount of academic evidence showing that passive investing performs better than active and, tellingly, no evidence showing active performing better. One example of academic evidence in support of passive is https://scholarworks.wmich.edu/cgi/viewcontent.cgi?article=4632&context=honors_theses
[iv] The Wilshire growth / value index is a handy indicator for analysis of whether US markets favour growth or value: https://www.longtermtrends.net/growth-stocks-vs-value-stocks/
This document is marketing material for a retail audience and does not constitute advice or recommendations. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amount originally invested.