Factor Investing Funds Offer an Interesting Approach
One of the drawbacks of funds is their singular approach to managing cycles, which means walking a certain path and not straying. Factor investing is at least more dynamic.
People will often speak of this or that type of stock being more suitable for this or that environment, and even though this view is ruled more by myths than reality, there are certainly times where certain types of stocks perform better.
The default approach is just investing in everything with the expectation that all this will walk the walk they expect over time, and then just hang on over time and expect to see this. With stocks, this has been true over the last few decades, as opposed to various times in the past where being in stocks at all have been questionable, during some very enduring bear markets.
There are some who think we may return to those olden days, those who really don’t understand the changes that the new frontier of stock investing has undergone, as well as our approach to managing our economies. When you combine just how much investing has exploded in the 21st century, together with how stable economies have become over this time, this new ship is bigger, faster, and more reliable, and this needs to be accommodated by our investment decisions.
We have separated stocks into two main categories, which we call growth stocks and value stocks. By nature, growth stocks are more volatile, and since they both go up and go down more than other stocks do, including value stocks, many investors want to try to confine themselves to being on the right side of the overall direction of the market.
This has become much easier over the last few years, as we just have moved ahead, and we should have been riding the faster horses or even the fastest ones. It’s not even been enough to be in growth stocks if we wish to take well advantage of these good times, we need to be in the sectors that grow the most, and that means technology these days.
What happens though is that people allow fear to shape their investment decisions too much, and the difference between fear and risk is that risk is something that we can manage, which flows from reasoning, where fear is an emotion and steps up to bat when reasoning is relegated to the bench.
This causes us to choose a more conservative approach than would be optimal and actually causes us to significantly dilute our upside. While we may be afraid of the potential downside, the true art of managing investments is centered upon enabling the upside while limiting the downside.
The most natural approach to managing higher risk is to place controls on it such that we can step aside when we need to and avoid what all these people fear. People who would hold an index fund like a blind trust actually have a pretty big risk appetite, one that would be considered to be way too high generally by those who go with the hot stocks when they are hot and step away when this higher heat starts to burn them a little.
However, in a world where the great majority of people want a blind trust, the idea of actually doing something to help yourself while in your positions is not one that holds much appeal. Anyone who shows such an appalling lack of interest in this surely can’t be counted on to hone their skills to the point where they could actually benefit, although the fundamental cause of this lack of motivation is ignorance, which the investment industry promotes so shamelessly.
Those of means can invest in hedge funds, which actually do have someone capable at the wheel in many cases, although these ships can also be guided recklessly and even crash on the rocks once in a while. You want a captain that knows how to navigate and also has full access to the tools to do this right, not try to guide one that only turns one way and not the other and can’t slow down or change course, or being left to its sails with no rudder at all and be taken wherever the wind blows.
Most investors don’t qualify to invest in such things, and have narrowed their field to going with various types of funds. The best they can do with this is to commit to a certain mix, and not have the means or the will to adjust to changing conditions as hedge funds can. This would require decisions and actions on their part and they are not at all interested in doing either.
Factor Investing Actually Has Someone Behind the Wheel
This is not to say that the blind trust approach doesn’t work that well, depending on what we put into these trusts. As it turns out, the speedboats travel further over time even though they may break down more along the way than the slower boats do, and it’s where we end up that matters, and not necessarily the course we took to get there.
If we load up with the slow boats, and almost everyone has way too many of these in their trusts, the ride may be a little smoother but if we end up way behind at the end of the race, this has been of no benefit. Index funds are actually too slow, and many see them as too wild and will go even slower, like with something called a value fund, comprising of a fleet of the slowest boats on the water.
There is a type of fund called a factor fund that is really gaining in popularity these days. Factor funds have been around for almost 40 years now, but few investors have ever heard of them. Factor funds such as the Investco Russell 1000 Dynamic Multifactor ETF are now making the news, and having the terms dynamic and multifactor in the name of the fund sure sounds promising at least, as these are the qualities that funds so sorely lack.
Their approach is to vary their holdings based upon both the amount of economic growth that we are experiencing and the VIX, which is a measure of how volatile the options market is. They will lean on growth or value stocks more depending on how these factors present themselves.
Without even looking any further, we can say that if you are coming from value investing, this approach will both serve to improve your returns by the more spicy mix in factor funds, and also provide you with a level of comfort, or at least the perception of it, beyond what index funds provide and especially beyond growth funds, which are the antithesis of value funds and considered particularly taboo by value lovers.
Let’s take this factor fund out on the road for a test drive to see what its strengths and weaknesses may be and to see how it measures up to the competition.
The first thing we need to examine what is under the hood, what it tracks, economic growth and the VIX. Data from these two indicators provides the fuel, so a good place to start is to examine the quality of these fuels, how changes in them correlate to the changes in stock prices that they are attempting to manage.
Economic growth is not at all correlated enough to stock prices, and in fact, over the last decade, we have both historically low economic growth and a historically strong stock market. Since this fund relies on low economic growth to cause us to back off the gas, this alone puts our car straight into the ditch on its roof.
The VIX can be helpful in timing investments, by using it to understand risk better when your stocks are declining, but it doesn’t match up with economic growth either. The VIX is also only useful in certain circumstances, and only in relative terms, where it is the rate of change that means the most.
An example of this would be last fall when stocks started to tumble and the VIX moved up quite a bit. The rate of change with both stock prices and the VIX was a real alert, although the value of the VIX only really spiked to an alert very late in the move. Otherwise, the VIX just bobs up and down in a way that really doesn’t harmonize with anything, and especially with economic growth rates.
We might think that this surely should be a piece of junk, but when we take it out on the highway, it is surprisingly quick and adapts to the road conditions much than index funds do, although this is because index funds don’t adapt to anything. There is much more under the hood with this one than we have been told.
The current yield of our factor fund looks far more like it comes from growth stocks than the S&P 500 and especially not from value stocks whose beat down prices put yields up. This is top heavy with growth stocks now but has been less so last year, and this has adapted quite well.
There is only one way that they could do what they do and that’s to index the thing to some degree to stock prices. This isn’t in the manual though and perhaps they preferred not to tell us this because it may make a lot of their target market anxious, rather than appearing to attach it to macroeconomic fundamentals which certainly sound more anchored to the ground.
How This Factor Fund Measures Up to the Competition
The opposite is true actually, but not a lot of investors know this, so this looks like a brilliant move. This fund has only been around since November 2017, so it doesn’t have much of a history, but what history it does have is pretty impressive. What we saw when we drove it is that it behaved like the S&P 500 on the way down but like the Nasdaq on the way up.
This is a very enticing mix. It dropped the same 20% as the S&P 500 from top to bottom during last year’s little bear market, but year-to-date, it is up an impressive 33%, similar to the Nasdaq. This is not all that higher than the S&P has done, but what makes this so notable is that there is only one way that this would be possible and that would be to lean harder toward growth stocks this year, a trick that indexes can’t pull off.
This does beat the S&P 500 overall, at least over the last year, but how does it measure up to a real growth fund such as the Technology Select Sector SPDR fund? The technology part should tell you that this is a high-octane fund and should leave our factor fund and just about everything else in the dust, and it doesn’t disappoint with its YTD gain of 49%.
We need to see how well they performed against one another over both the good and bad times though to declare a winner. During last year’s pullback, our sector SPDR actually only gave up a couple of extra percentage more than the S&P 500 and our factor fund. To see how this all fits together, since September 17, 2018, the tech SPDR is up 21%, while our factor fund has only grown by 14%.
The S&P 500 comes in third overall with less than a 9% gain over this time. Given how massively we invest in this index, this should serve to at least give us pause for thought. The Invesco multifactor ETF is both faster and more responsive than the big index, which isn’t responsive at all and is best used as a pace car not one you race.
The star of this show is clearly the tech sector SPDR, and at the end of the day, it’s return that matters. People who held through last December find this well in the rear-view mirror now, and where you were in the past does not matter at all now, as it never does.
This handily beats the S&P 500 across all time frames, and its 10-year return of 405% leaves the S&P 500’s 289% well behind. The only real time it was shown up was during the massive crash with technology stocks in 2000, but it was just insane to ride them all the way down. We buckled up and were told this is the tech bubble bursting after all, and people actually did heed this to the extreme actually.
Where you got off the ride is what matters here though, and there were degrees of sanity present, and we of course want to be on the saner end of things, when people’s faces turn sour and they are panicking about your sector.
This had disaster written all over it though, and even when things were blowing up to the upside, we could see this coming, and the risk was all over the media well before things crashed. This does go to show though that the faster the car, the more attentive to the road we need to be, and while we rarely may need to just pull over, those times can come.
There’s nothing on the horizon of this sort or anything close to it right now though, so road conditions remain excellent and the clear road that we’ve been on remains clear for as far as the eye can see. This factor fund may appeal to the value investing set, but nothing beats racing with a fast car with clear road conditions.
Chief Editor, MarketReview.com
Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.
Contact Ken: ken@marketreview.com
Areas of interest: News & updates from the Federal Reserve System, Investing, Commodities, Exchange Traded Funds & more.