Let’s assume you’re shopping for a new car. Since it can be a confusing experience, with many options, you consult with a friend who’s an expert on automobiles. He tells you to buy a car with the following specifications, and not be concerned with anything else:
Armed with this knowledge, you visit a number of new car dealerships. You identify 5 cars that meet these requirements, but the price range is significant, ranging from $30,000-$45,000.
Which car do you purchase?
In a perfectly logical world, you would buy the least expensive car. It has all the items your friend told you were important. He also told you “not to be concerned with anything else.”
You are well on your way to understanding factor-based investing.
Smaller investors who invest on their own, shouldn’t be concerned about factor-based investing. If you fit into this category, you will be well-served by focusing on keeping your costs and fees low, ensuring your asset allocation is suitable, and investing in a globally diversified portfolio of low management fee index funds, readily available from fund families like Vanguard, Schwab, and Fidelity.
Another option is the “three index fund portfolio” I recommended over a decade ago in The Smartest Investment Book You’ll Ever Read. In his recently published book, The Boglehead’s Guide to the Three-Fund Portfolio, Taylor Larimore affirms the wisdom of investing in these funds, and provides ample evidence that doing so “outperforms most investors with less risk.” I highly recommend this short, well-researched book.
I can define factor-based investing simply, but implementing it is complex. In this white paper, Vanguard defines factors as the underlying exposures that explain and influence an investment’s risk.
Some “factors” have been identified through extensive research as correlating with “historical positive risk-adjusted excess returns.” In straight talk, this means that you can explain the higher returns of portfolios by analyzing their exposure to those factors.
For stocks, Vanguard identified these factors:
Increasing exposure to these factors may generate a positive return premium over the long term, in excess of the returns generated by a comparable portfolio of low management fee index.
If you knew increasing exposure to these factors would increase your returns in the future (which is far from certain), you would do so by buying the lowest cost funds available that incorporated them.
Implementing a factor-based approach to investing is beyond the competence of most investors. The Vanguard White Paper (referenced above) discusses the challenges in detail.
To learn more about factor-based investing, read this White Paper from Vanguard. I also highly recommend Larry Swedroe’s excellent book, Your Complete Guide to factor-Based Investing: The Way Smart Money Invests Today.