Factor investing has been around for nearly three decades, but in recent years many advisors and investment companies have embraced it with a new intensity.

Underlying the uptick in interest is a growing belief that factor investing, when used correctly, can generate superior returns for client portfolios. That’s the view of Mark Balasa, co-founder and chief investment officer of Balasa Dinverno Foltz in Chicago. An early adopter, his $4 billion RIA now uses factor funds and ETFs for 90% of its equity portfolios.

For many advisors, examining the investment landscape through a factor lens produces a more granular picture of the choices and exposures they can create for clients. Some see it as an advanced, second-generation version of the traditional style-box perspective used by giant fund research concerns like Morningstar. Most academics in finance believe there are five genuine factors—value, quality, momentum, small cap or size and minimum volatility—that create more targeted options than capitalization size and growth versus value. 

When he explains factor investing to clients, Balasa draws a continuum starting with pure index investing, then moving on to factor investing followed by quant methodology and finally active investing at the end. Factor investing proponents adhere to various rules-based methodologies to deliver exposures to various sectors of the equity market and harvest premia over traditional market cap-weighted indexes.

While many established RIA firms have delivered decades of solid outcomes to clients using factor funds, the reality is that the last few years have been challenging—at exactly the same time these strategies have proliferated. Twice in recent months, Peter Lazaroff, co-chief investment officer of Plancorp, has found himself at an event where AQR Capital Management founder and CEO Cliff Asness, a thought leader in the field, was delivering the same address. His message: Essentially, nothing is working.

It wasn’t supposed to be that way. Many expected that increased computing power and data availability should be spawning more opportunities for index designers and both rules-based and active managers alike. As Lazaroff sees it, while traditional indexers view security selection as a zero-sum game, factor investing presumes that markets and prices contain vast quantities of information that can be harnessed to construct portfolios that deliver superior returns.

Academic research still indicates he is right. However, the consensus ends when it comes to product design and implementation.

Quality And Low Volatility

In recent years, two factors, quality and low volatility, have attracted billions in assets from advisors and investors seeking to participate in what they see as an extended, late-cycle bull market while getting a degree of downside protection. These two factors are complementary and share many similarities but also have key differences.

Simply put, quality factor portfolios tend to capture more of both the market upside and downside than low volatilty counterparts, according to Holly Framsted, head of factor ETFs for BlackRock. Quality portfolios tend to feature stocks with strong balance sheets, high returns on equity and consistent, highly predictable profitability. Minimum volatility mutual funds and ETFs, in contrast, tend to focus on trading dynamics and sport stocks with the lowest market betas.

Both strategies often feature dividend-paying stocks, offering income to yield-starved investors while smoothing the ride, Framsted adds. If, as many believe, the expansion is late cycle, low volatility’s relatively strong performance should come as no surprise.

High volatility stocks tend to be lower quality, while low-volatility stocks may or may not be, according to Mike Hunstad, head of quantitative strategies at Northern Trust Asset Management. The author of a paper on factor inefficiency, Hunstad has examined why the performance of factor funds varied so widely in recent years. He has developed a factor efficiency ratio that takes a fund’s risk exposure to the intended factor and divides it by the risk exposure to all factors.

Low-vol’s strong performance in this and other cycles flies in the face of Nobel laureate William Sharpe’s capital asset pricing model, which contends that the only way to improve returns is to increase risk. After all, Hunstad notes, 70% of equities’ return over the last century is attributable to dividends, and income stocks on average have less risk. “There are other forms of systemic risk besides beta,” he explains.

Yet why was the variance of low-vol factor funds so widely dispersed last year? One reason was that some had excessive exposure to interest-rate-sensitive sectors like utilities, REITs and consumer staples. As rates climbed, many stocks in these sectors got crushed, though some have rebounded smartly this year.

Hunstad has another theory. Many factor funds are poorly designed and take unforeseen risks by overweighting sectors, countries and currencies. “If you are not careful, you are taking a lot of unintended risk,” he argues.

Sector neutrality, in his opinion, is the best way to minimize unintended risks. Maintaining sector weight similar to the benchmarks avoids this problem. But many believe the more stringently a fund adheres to sector neutrality the greater the odds that it tracks the overall market.

BlackRock’s Framsted thinks a factor strategy can make sector bets, but investors need to understand them. With quality strategies, most of the metrics employed by institutional investors tend to lead funds to favor companies with low leverage. That can tilt a fund toward certain technology companies and away from financials.

But one can find “quality within each sector,” she adds. Indeed, there are banks with fortress balance sheets, though many financial companies that meet quality factor screens are often service- or transaction-driven like the big credit card concerns.

Momentum

No single factor has characterized this 10-year bull market more than momentum. It’s a relatively new and controversial factor, and some experts like Research Affiliates founder Rob Arnott still question its viability. Dimensional Fund Advisors, the granddaddy of factor investing, doesn’t offer a momentum fund, though DFA disciples say the firm incorporates the factor into its trading strategies.

But momentum stocks aren’t hard to identify. Essentially, if one took the highest-octane components out of either Morningstar’s growth stock universe or the Nasdaq 100, one could create an ETF with Big Mo. And many have.

A landscape dominated by disruptive technology giants growing earnings at rates of 20% or more provided the investing theme of the decade. When set against a backdrop of near-zero interest rates, those earnings are perceived as even more valuable.

There is only one problem for investors who want to isolate this kind of unbridled euphoria. Momentum has an uncanny habit of turning on a dime. That’s why many funds and ETFs following this factor rebalance monthly. As a result, the factor’s turnover, trading costs and tax consequences can rival those of hedge fund strategies. Most other factor strategies rebalance quarterly or semiannually. Matt Bartolini, head of Americas research at State Street’s SPDRs unit, argues the costs associated with momentum “can decay” much of the premium associated with the group.

Despite its obvious attraction in the 10-year rearview mirror, momentum also leaves portfolios exposed to tail risk and sudden sentiment shifts. That became evident in last year’s fourth quarter. “Momentum works really well in a continuous up market,” says Duy Nguyen, chief investment officer and senior portfolio manager at Invesco Investment Solutions. “It does not tell you when the inflection point is coming.”

According to Bartolini, the performance of both quality and value factors correlate more closely with different stages of the economic cycle than momentum. Specifically, he says, value tends to work well early in the cycle while quality often does best late in an expansion.

Critics argue that momentum is really just a form of performance-chasing that can get you into hot stocks late in the cycle. In early November, Jim Cramer, co-founder of TheStreet.com, raged in public that the liquidation in momentum ETFs was vaporizing the value of his Visa and Mastercard holdings. Other stocks favored by momentum funds, most notably the FANG stocks, also got slammed, but many of the latter group had specific problems of their own (such as regulatory issues).

Observers thought that blaming ETFs for the rapid depreciation of this factor was simplistic. In a risk-on, risk-off world, more hedge fund managers probably jump in and out of white-hot stocks faster than momentum ETFs do.

Among the sophisticated institutional investors Hunstad deals with at Northern Trust, there is a growing cross section of investors and managers preparing their portfolios for a downturn, and they also believe that portfolios overexposed to momentum stocks are highly vulnerable. “Correlations among sectors are declining, and there is more individual stock dispersion,” Hunstad says. Yet giant firms like BlackRock and Northern Trust are still not calling for a recession.

Few believe that U.S. equities are near 1999 levels, though there are some similarities. Fully 95% of the price of Amazon, probably the leading momentum stock, is “based on future earnings,” Hunstad maintains. “They are going to have to grow to 10% of GDP over the next 10 years to justify that.”

Value

Long before factors were discovered, value investing was rewarding investors with excess returns. Benjamin Graham shared the concept with readers of his books Security Analysis and The Intelligent Investor. Warren Buffett put it into practice for the public to see.

It may be the first and oldest factor, but value is experiencing an extended bout of underperformance. “A lot of people are wondering if value is dead,” Plancorp’s Lazaroff says.

After President Trump was elected with promises to rebuild smokestack America, many people thought that value would start to outpace growth. It came close in 2017 but has not kept up with most other factors or the major indexes since then.

In an age of disruption, many once profitable industries are under siege from upstarts. Executives at active investor T. Rowe Price have suggested value could continue to struggle given the secular transformation some believe is coming in the next decade.

“The challenge for value today is that it is dominated by financials and energy,” says Emily Roland, head of capital markets research at John Hancock Investment Management. If one likes value now, she says they need to believe that energy prices will appreciate and banks can grow profits in a low-interest-rate world with an inverted yield curve.

Still, throwing in the towel on a strategy that has outperformed growth for almost a century seems myopic. Mark Balasa, Lazaroff and many other advisors believe that most growth stocks are seriously overvalued. Hunstad says institutional investors seeking downside protection are looking closely at value today.

What’s striking is that over the 10 years ended July 12, value actually produced solid gains that might have left investors quite satisfied in another decade. BlackRock’s large-cap value ETF, labeled IWD, has returned 12.98% versus 16.06% for IWF, its large-cap growth ETF. (These ETFs are designed to track the Russell 1000 large-cap value and growth indexes, respectively.)

Recent history also shows that when value shines it can be powerful and offer protection. Rarely was this more obvious than in the years 2000 to 2004, when the tech bubble popped and the market punished profitable high-growth companies with almost the same vengeance it did bogus dot-com stocks.

“When value outperforms, it outperforms by a wide margin,” Invesco’s Nguyen says. “It’s hard [for people] to see that today.”

At the same time, value can also get very expensive and lose Ben Graham’s prized margin of safety. Just recall the shellacking that energy, materials and financial sectors suffered in 2008.

The Small-Cap Premium

Academic research indicates that small-cap stocks outperform the market over time. Yet once again, that research is being questioned now for a host of different reasons.

Skeptics point to the dramatic shrinkage in the universe of public equities over the past couple of decades: The number of public U.S. companies is about 50% smaller than it was in 1999.

The boom in both venture capital and private equity has driven this phenomenon. Venture-backed companies are waiting much longer to go public than they did in previous cycles. At the same time, private equity concerns are flush with cash they have to invest, thus they are gobbling up small-cap and mid-cap businesses.

Some believe that many of the best investment opportunities are no longer available in public markets. An investor who bought onetime small-cap Amazon after its 1997 IPO earned a return of about 800 or 900 times the IPO price. Contrast that to a 20-fold increase in Google since it went public in 2004 or the quintupling of Facebook since its 2012 IPO.

The trend of keeping start-ups private longer is only accelerating—there were recently believed to be about 260 so-called unicorn start-ups valued at more than $1 billion, according to CB Insights. At last year’s Inside Alternatives conference hosted by Financial Advisor in Las Vegas, iCapital managing partner Nick Veronis told attendees that today’s VC firms and private investors seem eager to “extract most of the value out of their portfolio companies” before bringing them public.

Much ink has been spilled on how the indexing boom drives up the prices of mega-cap growth companies, but some believe its influence on small-cap equities is even greater. That’s because they are less liquid and fund flows can drive even more extreme price swings in this sector.

Multifactor

It’s not clients’ risk tolerance that poses the biggest challenges to advisors but rather, in Lazaroff’s view, clients’ tolerance for tracking error. In recent years, their exposure to value and small-cap stocks has caused their portfolios to stray from the S&P 500.

The fund companies “don’t have to worry about advisors losing faith,” Lazaroff says. “They have to worry about [advisors’] clients losing faith.”

That explains why many asset management complexes are rolling out multifactor portfolios by the boatload. For example, when momentum is combined with value and quality or minimum volatility, clients won’t be hurt as much by exposure to any single factor.

Even with multifactor portfolios, consistency is paramount. Framsted says BlackRock conducted a survey several years ago of traditional active managers who outperformed their benchmarks. It found that active managers who had outperformed over the time period analyzed, a majority of the excess returns came from static factor exposures.

She thinks investors should have all five major factors in their portfolios. Whether they are overweight or underweight depends on the client.

Can multifactor investing be timed in the same fashion that some professional investors deploy sector rotation? Balasa says most of the serious research on this subject isn’t encouraging. It strongly suggests the best alternative is to select a factor weighting appropriate for the client and leave it in place.

State Street’s Bartolini goes further. “If you are timing factors, you are playing with fire,” he warns. If the goal is timing, he goes so far as to advise that it be executed at the single stock level, not with ETFs.

Logical though it sounds, broad multifactor diversification begs another question. Why not just buy the total market index?

The answer will likely emerge after the next major bear market when advisors will find out if factor investing really lives up to its billing and delivers excess returns with a lower beta.