Determining the most desirable way to grow wealth
High returns at low costs are the goal of every investor. And savvy investors know that passive and active vehicles both have benefits and disadvantages which must be assessed in light of a specific investment strategy.
A third way that has both passive and active elements—factor investing—is being embraced by many segments of the investment world. It’s based on the idea that the risk and excess returns active managers endure and earn boil down to a specific set of shared stock characteristics like value or momentum. Factor investors methodically leverage these factors to provide a powerful boost to a portfolio, realizing higher returns than the broader equity market at substantially lower costs than traditional active strategies.
Factor investing: Proper implementation leads to higher returns
When designed properly, factor investments are transparent, provide exposure to widely-accepted sources of expected returns, and offer low management fees and reasonable transaction costs. Diversification created by the low-average correlations of most individual factors shared by a set of stocks also mitigates the risk of underperformance.
When the strategy is well-implemented and relies on well-researched factors, factor investing has the potential to enhance an investor’s investment choices and increase a portfolio’s long-term risk-adjusted returns.
But the risks of some factor investments can be understated, and the diversification elements exaggerated. A properly designed use of these vehicles will provide these benefits but it’s important to assess the individual investments and their place within an overall strategy. Since factor returns generally deviate from normal distributions—and since correlations between some factors are inconsistent over time—attempting to diversify with multi-factor portfolios doesn’t necessarily end exposure to the risk drivers of each individual factor. That means portfolios invested in multiple factors could still suffer drawdowns and periods of underperformance.
Poor implementation can eat away at a factor’s return benefits and lead to unexpected and unsatisfactory outcomes. Not fully understanding the risks of this strategy can also cause investors to begin or withdraw at inopportune times instead of having the discipline to weather temporary underperformance.
Grasping factor cyclicality is essential for factor investing: factors do often show excess risk-adjusted returns over long horizons, but they can exhibit significant cyclicality over shorter periods.
Index investing is a straightforward strategy
Examples abound of investors who beat the market for a period of time with traditional active investment strategies. But it’s nearly impossible to do so on a consistent basis over the extended periods most people invest—and there’s no guarantee that an investor (or fund manager) who did it once will do it again in the future.
Building wealth and saving for retirement doesn’t have to be complicated, expensive, or time-consuming. The world’s most famous investor, Warren Buffett, has long championed the passive index investment strategy as the most sensible way to invest—even instructing the trustee of his own estate to sock 90 percent of the cash into low-cost index funds.
Index investing offers those tired of trying to beat the stock market a simple way to gain market returns. In fact, low-cost, passive index funds that track broad indices and are held long-term make no attempt to distinguish between attractive and unattractive securities, to time markets, or to forecast securities prices. The justification for this approach is backed by numbers. For example, during the five years ending December 2018, 82 percent of actively-managed, large-cap funds generated a return less than the S&P 500.
As a large package of stocks that mimic the profile of a particular index, broad index funds offer patient investors without the time or expertise to chase performance the best likelihood of consistent returns over time while minimizing the risks of individual stocks. Not only does index investing generally offer low annual costs, there are also usually no hidden fees for regularly increasing investments. The low turnover makes them tax efficient. And if the index that’s tracked is broad enough, it’s easier to achieve a well-balanced portfolio.
Index funds are a solid way to see strong long-term returns: since the market generally outperforms any single investment over a long enough time horizon—and an index fund can mirror the broader market—they have the same return, minus the lower fees. Over the past 90 years, the S&P 500 averaged a 9.53 percent annualized return, meaning $10,038.47 invested in the S&P 500 in 1955 was worth nearly $3.3 million at the end of 2016.
There are some downsides to index investing to consider. Since the assets making up a fund’s portfolio can fluctuate, it can be difficult to see exactly what you own. The funds are certainly vulnerable to market swings, whereas some actively managed approaches may move in the opposite direction during a downswing.
There is also limited upside—by definition, index investing can never beat the market it tracks, but simply grows consistently beside it. Investors seeking higher returns who can also stomach higher risks, or those who prefer to be in control of their investment strategy, may feel more comfortable with other opportunities.
The bottom line: Factor and index investing each have their place
Factor investing continues to gather momentum in the investment world, and looking past the label of asset class to the underlying factors that drive returns offers the potential for greater upsides. But factor investing must be done intelligently, as poor implementation and failure to understand and account for risks can limit the benefits of this strategy.
Market-matching index investing offers a straightforward, diversified way to grow wealth and enjoy strong returns over long horizons, but it may have a more limited upside.
In the end, the right approach depends on which one works for your goals, and a qualified investment advisor can help you leverage the best strategy—or a mix of them.
Lindberg & Ripple is an independent investment and insurance advisory firm providing sophisticated Wealth Management, experienced Investment Consulting, and innovative Insurance Solutions for wealthy families, successful executives and business executives. Contact us to learn how we can help your family or business achieve your financial objectives, while minimizing hassle, expense, and taxes.