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Are Factor Funds Good For The Long Term?

  • Factor investing is based on empirical evidence on what types of stocks outperform the broad market

    • If we took the S&P 500 stocks today which stocks would do best?

      • Cheap stocks (value)

      • Those with rising stock prices (momentum)

      • Small stocks (size)

      • Low-risk stocks (low volatility)

      • Stocks with strong balance sheets & good earnings growth (quality)

    • This is the kind of question Jim O’Shaughnessy was trying to answer with “What Works on Wall Street”

    • Think of it like a mechanical, rule-based active approach

    • Eugene Fama & Kenneth French were the two researchers to lead the way from the academic side

    • We’ve got a lot of explainers on factors

    • But….
    • Factors often go through decades of underperformance

    • Could you stick with a factor that long?

    • The headwind for this kind of investing is cognitive

  • See the latest factor data from Fama & French below

  • We can see that

    • Small-caps have been underperforming for about a decade (lower green line going down)

    • Value has been underperforming since 2007

    • Can you hold on for that long in the belief that the research will prove you right?

  • Incidentally, the dashed red lines are periods of maximum S&P 500 concentration in the largest 5 stocks (1991, 2000, 2008, 2012 and 2020) and sometimes coincide with a reversal in factor outperformance (and recessions)

  • Factor funds are usually a big slice of beta (track the market) with an overweight to a factor that intermittently delivers alpha

  • It’s difficult to love that proposition but if you do you’d substitute one of these funds for your global equity exposure (or specific market exposure)