Eugene Fama holds a place in the sporting hall of fame of Malden High School in Massachusetts. In the 1950s Fama was second in the high jump at a state-wide meeting and was part of the school’s state champion football team. It was a rather unorthodox upbringing for a future Nobel prizewinning economist.
Research by Fama, the son of a truck driver who worked in the shipyards during the Second World War, has shaped how many people invest today. A 1970 paper by Fama, a third-generation Italian-American, on efficient capital markets showed that there was no way to predict short-term changes in the prices of stocks or bonds. This helped to pave the way for the launch of passive funds, which simply track a market index rather than relying on a human to pick shares.
Alongside his fellow economist Kenneth French, Fama then wrote a 1993 paper showing that it was not solely a stock’s beta — a measure of its volatility — that explains its average return. After analysing 120 years of data they identified three factors that could describe market returns, and later added two more. This led to what’s known as factor, or smart beta, investing.
Factor investing is a way of harnessing the elements identified by French and Fama to squeeze out returns above the average stock market gains.
The factors are: value (companies whose share prices are trading below the value of their business); size (smaller companies); low volatility (stocks that exhibit lower risk); momentum (stocks whose shares are trending upwards); and quality (financially healthy companies).
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The idea is that investors can target different factors depending on their investment objectives. For those able to tolerate more risk, momentum would make sense; more cautious investors can consider low volatility, or quality.
For most of us, trying to pinpoint the different factors is not possible because we lack the time or expertise, or both. For this reason there are funds that do it for you.
BlackRock’s passive investment business iShares launched a suite of smart beta exchange traded funds (ETFs) between 2012 and 2015 to tap into the trend. Companies also offer funds that combine some or all of the factors into a one-stop factor fund shop. But the theory has so far seemed better than putting all this into practice.
Fast-forward 28 years from French and Fama’s original paper, and the strength of their factors is being questioned. Of the five iShares factor ETFs that are based on the MSCI World global stock index, only two — quality and momentum — beat the iShares Core MSCI World ETF. These are poor results for investors, but it is no surprise that the smart beta funds have failed. Arguably, it goes to show the pitfalls of falling for marketing hype.
It is worth keeping the faith with the factors, though. Over longer periods of time smaller companies will generally grow faster than their larger counterparts, and value will probably have its day in the sun once more, even if it’s out of fashion now.
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Jason Hollands, a director at the wealth manager Tilney, said that US investors who wanted to pare back their exposure to the biggest and most overvalued stocks in the market might consider a factor fund.
Passive investors should ensure their portfolios remain balanced. For many, a global index tracker fund will do the job, but for others it gives them too large a weighting to Amazon, Apple, Google and the like.
Hollands said that the Invesco FTSE RAFI US 1000 ETF, which follows factor investing principles, could act as a counter to a vanilla S&P 500 tracker. The fund holds the largest 1,000 US companies, but weights them using sales, cash flow, book value and dividends, rather than market capitalisation alone.
Active fund managers can largely be bucketed into each factor. They charge more than smart beta ETFs, but can give a more targeted approach and offer the chance for a bigger outperformance.
Lindsell Train Global Equity and Rathbone Global Opportunities, for example, have been able to beat the quality factor. Investment trusts such as BlackRock’s Throgmorton have done well on the size factor, and Schroder Global Recovery has done likewise as regards value.
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I’ll keep the faith and continue backing these managers in a balanced portfolio, alongside my global equity index tracker of choice, the L&G International Index Trust, and some bond and alternatives funds.
