After 2 years of avoiding COVID, I was finally caught by the Omicron variant last week. Luckily I had already finished my second post of that week so only my marketing went quiet as I laid in bed and fought it off over the next 4 days. Although I am still in recovery mode, I am well enough to make a stab at continuing my posts this week.
I struggled with what topic to write on this week but luckily I keep a tab of post ideas when they come to me just in case I am struggling later. Mostly my struggle tends to be with which topic to focus on rather than having nothing to write about. There are a million things that I could write a few paragraphs about but it takes more effort to go in depth. Luckily I had a good one in my pocket from a few weeks ago I hadn’t written about yet.
Factor ETF’s
What does it mean to beat the market? Most novice investors have a fairly good idea of what they consider “the market” even if they don’t think about it that much. Many equity investors and financial media think of the S&P 500, in the past they may have considered the Dow Jones Industrial Average. If you’ve never stopped to think about what those are, I will briefly introduce now to how they are constructed and what factors have to do with their construction. Finally, I will get into why diversifying factors may be just as important as diversifying your share holdings.
A factor is a characteristic of a stock or index. It’s easier to understand with some examples. One common factor includes small capitalization stocks, or those companies with $300 million to $2 billion in market capitalization. Value is also a factor, as well as growth and momentum. The indexes I mentioned above, actually exhibit factors themselves, they aren’t the entire market.
In the case of the Dow Jones, it consists of 30 stocks hand picked by a committee due to their consistent earnings (quality factor) as well as large capitalization (size factor). In the case of the S&P 500, the index consists of large capitalization companies ranked by their size. If we break these down into their factor descriptions we could say the Dow Jones is a large cap, US, quality factor based index consisting of 30 companies.
In the case of the S&P 500 we may say that it’s a large cap, US, momentum based index based in its ranking by market cap. Keep these in mind as I move around because they will become important concepts further down.
Active Share and Weighting
One of the more interesting concepts I took away from my CFA studies was the concept of active share and active risk. Active share is a concept used to evaluate fund managers which examines their benchmark (what we called their market above) and looks to see how they invest in the shares of the benchmark to see if the manager adds value.
There is no escaping the benchmark for an active manager. The manager either has to hold the companies in the benchmark or the benchmark is not appropriate for evaluating that manager. For example, a large cap US manager cannot buy IDEX Corporation as her sole holding and claim to be beating their benchmark. Their appropriate benchmark would not be the S&P 500, it would be the CRSP US Small Cap Index.
Now once you have your benchmark you have a choice as to how you want to invest. Will you simply track the index, or will you take more risk to try and beat the index? If you do try and beat it you essentially have variations on 2 options: own more of a few stocks than the index does and hope those beat the index that holds them, or you weight different industries within the index based on how you think their fortunes will turn out. Either way your bet can be simplified into companies or sectors beating the index in any given year.
Evaluating Yourself
Now let’s extrapolate that and start to look at individual investors as little portfolio managers. What is your active share and what risks does it pose?
To keep it simple let’s take the example of a newbie Gen Z investor who holds Nvidia, Apple and Tesla. This investor is implicitly telling themselves that these 3 stocks will beat the Nasdaq 100. Indeed, this year they did, handily beating their benchmark with a 71% return (if held equally) compared to a 22% return for the benchmark. Yet the likelihood that this will continue gets lower as time drags on. The reason being is that as big companies grow even bigger they take up even more of the benchmark as they do. If these 3 stocks beat the benchmark for the next 20 years, they would eventually become so big that they would become the benchmark themselves and you would be back to just holding an index.
This investor is essentially betting that will happen but as many experienced investors know, the outperformance of a particular segment or company never lasts forever. Events beyond our prediction will happen in the future which can completely alter the investment landscape and create totally new winners and losers.
So if we look at this investor in terms of their active style, we can characterize it as large cap, US, technology, growth and momentum. These factors come and go over time and a period of outperformance is often followed by a period of underperformance. To illustrate, just take a look at how emerging markets performed versus the S&P 500 from 2001-2011 and then how the S&P performed in the subsequent decade:
What this starts to point to is that it’s not just diversity of companies which investors need to keep their portfolios growing but also a diversity of factor styles as well.
How to Diversify
This is not something only the wealthy can do. The good news is that through the magic of ETF’s, almost any investor can diversify their portfolio to invest in different factors. There are now ETF’s that follow value, momentum, small cap, mid cap, quality, liquidity and low beta styles among others. There has also been a decent amount of research done on how combining these different factors can benefit the returns and volatility of a portfolio.
Below you can see how different factors perform versus more conventional indices and why it pays to hold them.
Even the stalwart of the index fund, Vanguard, has recognized that this may be the next hurdle to get investors past and has released a number of different factor ETF’s for investors. Yet the easiest way to start for most investors will be to start to diversify into some of those boring funds they have been ignoring for some time: value, small cap and international funds, even yes that perennial loser, emerging markets.
On my own journey through diversifying factors I was lucky enough to invest in late 2019 in the Vanguard International Growth Fund, which jumped 200% after then March 2020 low point. Rather than remain complacent with my gains, I used these to diversify early in the year to US small cap and mid cap funds by selling down some of the international growth shares. This proved prescient as shares dropped as much as 20% in the last month.
This wasn’t profit taking but rather more of a risk rebalance. Due to the run up in those shares, I had a large exposure to foreign tech shares all of the sudden which needed to be managed. This is also the reason I keep many of my factor exposures in my retirement accounts, so that I can easily rebalance them without big tax consequences.
The Advantage of Spotting Long Term Trends
The other advantage of investing via factors is it allows you to spot long term anomalies and invest accordingly. As I have been touting in this blog for some time, both emerging markets and value shares have been looking very cheap for some time now. The longer their underperformance versus growth goes, the larger the upside we may see when they come back.
Being this long term oriented also helps me spot the ruses out there as well. This is one reason I am so negative on crypto. With no assets backing crypto and no underlying cash flow, it starts to look like a giant Ponzi scheme with betters hoping the next dummy will buy crypto off of them for even more than they paid. The words of one of the founders of Dogecoin, Jackson Palmer, should serve as a stark warning to anyone thinking of investing in crypto:
The cryptocurrency industry leverages a network of shady business connections, bought influencers and pay-for-play media outlets to perpetuate a cult-like “get rich quick” funnel designed to extract new money from the financially desperate and naive.
No one wants to be called desperate or naive. These illicit strong emotions, which may be one reason why so many crypto enthusiasts so vociferously defend their investments. Yet it will take time to show these new investors that skepticism, diligent research and experience pay off over the long haul. They are skills acquired over years of investing mistakes. Some of us learned those in the late 90’s or during the financial crisis, just like us, your time will come too, and that’s ok.
Meanwhile, the next huge returns are likely building in an area no one is paying attention to right now. It could be in foreign value shares, mining company shares as green investing becomes more important, or in a nascent industry yet to fully flourish like EV. One thing is for certain is that diversifying your investment by factors will position you in these areas long before other investors or the media shows up to glamorize it. Momentum, growth, value, small cap, large cap, micro cap, just about every company has fallen into one of these categories at one time or another so factor investing will enable you to capture the next gem without too much effort. Keep this in mind and you can invest without losing sleep no matter what the market does.
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