Index to Factor-Based Investing

The evolution from index to factor-based investing has become increasingly nuanced. Investors are recognizing a deeper understanding of market dynamics and investor behavior. Initially, the widespread adoption of index funds in the 1990s was largely attributed to the Efficient Market Hypothesis. This theory posits the stock market’s efficiency made it rare for active managers to consistently outperform passive benchmarks.

However, as behavioral finance shed light on the cognitive biases that often lead investors astray, the narratives began to shift. Now, the appeal of index funds extends beyond market efficiency. Encompassing their tax benefits, ability to mitigate investor biases, as well as their low-cost structure.

This progression from a singular focus on market efficiency to a broader recognition of the benefits of passive investing sets the stage for the rise of factor investing. Factor investing emphasizes specific market drivers or “factors” believed to influence returns. It offers an updated blend of the passive discipline of index funds by targeting returns beyond the broad market.

This blog post delves into the evolution of indexing towards passive factor models. We will explore how our understanding of index investing vs factor investing has grown over time. And, how the average investor might use this knowledge to their advantage. The post concludes with a look at how a simple, low-cost factor-based investing model can support a long-term, buy-and-hold approach.

Rise of Indexing

As index funds became mainstream in the 1990s, investors thought their superior returns were best explained by the Efficient Market Hypothesis. At the time, investors considered stock markets to be so efficient that they prevented the average active investment manager from beating their passive benchmark. Examples of this argument can be found in popular books of the time such as A Random Walk Down Wall Street by Burton Malkiel.

Behavioural Finance: The Missing Piece

However, during the 1990s index fund boom, behavioural finance was still on the fringes. In fact, Daniel Kahneman didn’t win the Nobel prize until 2002. But today, with the dangers of investor bias well-known, mainstream finance has recognized new reasons for the success of index funds. More than the Efficient Market Hypothesis, the outperformance of index funds may be more attributable to the reduction of taxes, the avoidance of investor bias, in addition to their low-cost.

Vanguard Launches an Index Fund

Vanguard launched its first index fund, the First Index Investment Trust (now known as the Vanguard 500 Index Fund), in December 1975. This fund was created by Vanguard’s founder, John C. Bogle, and it was the first index mutual fund available to individual investors. Its aim was to provide investors with a low-cost way to gain exposure to the performance of the S&P 500 Index, embodying Bogle’s philosophy of low-cost, passive investing. Over time, this fund and the concept of index investing have become mainstream, influencing the investment strategies of millions of investors worldwide.

Vanguard’s first index fund faced skepticism from the investment community at its inception in 1975. As the idea of passive investing was quite novel at the time. The concept of tracking an index instead of actively managing investments was contrary to the prevailing wisdom. However, as the superior returns of low-cost index investing became more apparent over time, index fund competitors emerged.

Index Funds: Growing Popularity

For individual investors, competition to Vanguard’s index fund offering began to heat up in the decades following the launch of the Vanguard 500 Index Fund.

A major competitor came from the first index ETF (Exchange-Traded Fund) that was launched in 1993. It was the Standard & Poor’s Depositary Receipts (SPDR), now commonly known as the SPDR S&P 500 ETF. The SPDR was also designed to track the performance of the S&P 500 Index. Providing investors with a new way to gain exposure to the overall U.S. stock market through a single investment using an exchange traded fund instead of a mutual fund.

The introduction of the SPY ETF marked a significant milestone in the financial industry, offering the benefits of index fund investing—such as diversification and low costs—with the added flexibility of trading like a stock on an exchange. This innovation paved the way for the proliferation of ETFs across a wide range of asset classes and investment strategies during the 1990s and early 2000s.

Index Investing: Initial Reasons for Success

When the first index ETFs were launched, they were touted for several key advantages that combined the best aspects of index mutual funds with the flexibility of individual stock trading. These advantages have contributed to the significant growth and popularity of ETFs among investors during the following decades:

1. Lower Costs: Index ETFs typically have lower management fees compared to actively managed funds. They aim to replicate the performance of an index, reducing the need for expensive portfolio managers and research costs.
2. Tax Efficiency: By design, broad market index funds such as those tracking the S&P 500 Index avoid frequent re-balancing. Once a stock is in the index, its proportional value simply reflects its current market cap. And so, no additional trading within the fund is required. The result is fewer capital gains taxes being incurred by an index portfolio. Only when new components are added or removed from the index are any capital gains or losses incurred by the fund.
3. Trading Flexibility: Unlike mutual funds, ETFs are traded throughout the trading day at market prices. This allows for strategies like intraday trading, and provides greater liquidity.
4. Diversification: Like index mutual funds, ETFs provide a way to invest in a broad segment of the market or a specific sector, helping to spread risk across many investments rather than relying on the performance of a few individual stocks.
5. Better Performance: Index funds have outperformed the returns from active management. This is one reason why index funds continue to gain market share vs actively managed funds.

These foundational benefits of index ETFs have remained compelling reasons for their use in investment strategies, appealing to both retail and institutional investors seeking efficient, cost-effective ways to achieve diversified exposure to various markets and sectors.

From Efficient Markets to Behavioural Factors

When index ETFs were first launched, discussions about market efficiency played a significant role in framing the arguments in favor of these investment vehicles. These discussions were rooted in the Efficient Market Hypothesis, which suggests that at any given time, asset prices fully reflect all available information. According to the Efficient Market Hypothesis, it’s impossible to consistently achieve higher returns than the overall market through stock picking or market timing, because all known information is already incorporated into stock prices.

During the initial phase of their introduction, these discussions about market efficiency were crucial in persuading investors and advisors of the value proposition of index ETFs as well as explaining why they were working. They highlighted the theoretical underpinning of passive investing in an era when active management was the dominant strategy.

However, our understanding of why index funds have outperformed actively managed funds has evolved over time. The reasons why index funds outperform often cited today reflect both an accumulation of empirical evidence and a deeper understanding of the factors influencing investment returns including behavioural bias.

1.      Empirical Evidence

Over the years, a wealth of empirical evidence has accumulated showing that index funds not only have lower costs but also tend to outperform a significant majority of actively managed funds. This evidence has been bolstered by annual reports like the SPIVA (S&P Indices Versus Active) scorecard, which tracks the performance of actively managed funds against their relevant index benchmarks.

2.      Behavioral Factors

Modern discussions about the performance of index funds now include insights from behavioral finance, which studies how psychological influences and biases affect the investment decisions of individuals and professional fund managers alike. These discussions highlight how behavioral biases can lead to suboptimal investment decisions, further justifying the passive approach to investing (but not necessarily indexing).

3.      Tax Efficiency

The tax efficiency of index funds has become a more prominent part of the conversation. Index funds typically have lower turnover rates than actively managed funds, resulting in fewer capital gains distributions and thus a lower tax burden for investors.

4.      Focus on Asset Allocation

There is now a greater emphasis on the importance of asset allocation over individual stock selection. Index funds are tools that allow investors to efficiently implement asset allocation strategies, which research has shown to be a primary determinant of portfolio returns compared to picking individual stocks.

5.      Widening of the Market Efficiency Debate:

While the Efficient Market Hypothesis provides a foundation for the argument in favor of index funds, there is now a broader acknowledgment of market inefficiencies. Exploiting these inefficiencies consistently and after costs is still alludes most active managers. This nuanced view acknowledges that while markets may not be perfectly efficient, the hurdles to consistently outperforming them through active management are significant and many would say, impossible in the long-run.

6.      Inclusion of Factor Investing

Discussions about index investing now also include factor investing, which involves constructing indexes based on factors that have been associated with higher expected returns, such as value, size, momentum, and quality. Or that target types of returns desired by investors (such as income, volatility, etc). This approach bridges the gap between passive and active management, offering a middle ground that still leverages the benefits of indexing (low-cost, avoid behavioural bias, diversified, etc) while attempting to capture excess returns by relying on empirical evidence or tailoring factors based on an investor’s goals and risk tolerance.

Index Investing vs Factor Investing

Overall, the narrative around why index funds typically outperform has shifted from a primarily cost and efficiency argument to a more comprehensive discussion that includes a broader array of evidence and factors, reflecting what we now know about behavioural finance and investor bias.

Factor investing, has indeed been gaining popularity as an investment strategy that aims to capture specific risk factors or market inefficiencies that can potentially lead to higher expected returns compared to broad market indexes. This approach sits between traditional passive index investing and active management, leveraging the benefits of systematic rules-based investing while seeking to outperform market-cap-weighted indexes.

What is Factor Investing?

Factor investing focuses on selecting securities based on attributes that are believed to be associated with higher returns or that match an investor’s unique goals and risk tolerance. These factors are typically proven through research and empirical evidence. As opposed to someone’s opinion. The most commonly recognized factors include:

• Value: Investing in stocks that appear underpriced compared to their fundamental value.
• Size: Preferring smaller companies with higher growth potential.
• Momentum: Capitalizing on the tendency of securities to continue their recent performance trends.
• Quality: Focusing on companies with high profitability and strong balance sheets.
• Volatility: Lower volatility stocks are expected to yield better risk-adjusted returns.
• Yield: Seeking higher (or lower) dividend-paying stocks.

Popularity of Factor Investing

The popularity of factor investing has been on the rise due to several reasons:

• Transparency and Systematic Approach: Like index funds, factor investing offers a transparent and systematic way to invest, reducing the reliance on fund manager discretion. Therefore, reducing investor bias.
• Potential for Enhanced Returns: By targeting specific factors, investors aim to achieve returns that exceed those of market-cap-weighted indexes, without the higher costs associated with traditional active management.
• Diversification: Factor investing can provide diversification benefits, as different factors may perform well under different market conditions.

Popular Types of Factor Investing Portfolios

Among the various factor-based strategies, value and momentum strategies are particularly popular, often due to their strong historical performance records. Quality and low volatility factors also attract significant interest, especially among investors looking for a more defensive investment strategy that can potentially offer more stable returns.

Performance of Factor-Based Indexes

The performance of factor-based indexes relative to broad market indexes can vary significantly over time and across different market cycles. Some factors, such as value and momentum, have historically outperformed broad market indexes over long periods, though they can also go through extended periods of underperformance.

It’s important to note that while factor investing seeks to exploit systematic risk premiums for better returns, there are no guarantees of outperformance. Investors interested in factor investing should consider their investment horizon, risk tolerance, and the potential for factor performance to diverge from broader market returns and work with advisors who can tailor a factor-based portfolio based on an investor’s specific objectives.

Factor based investing strategies, while positioned between traditional passive index funds and active management, generally adopt an approach that is more akin to a buy-and-hold strategy, like traditional index funds, but with some important distinctions.

How Should Investors Respond?

Considering our updated understanding of why index funds outperform active managers, how should investors adjust their own portfolios?

Investors should consider incorporating index funds into their portfolio. This doesn’t mean they should automatically make their portfolio based on index funds alone. Instead, investors should also consider other ways to incorporate index funds. Such as using index funds as portfolio benchmarks. And, using index funds within in a core-satellite approach.

Investors should also design investment policies that incorporate an updated understanding of the reasons why index funds outperform. This can mean using investment policies that support rules-based investing that avoids human discretion – thereby decreasing the capital gains taxes associated with more frequent buying and selling, and the negative impact of investor bias.

Our family office can draft investment policies that are easy to follow. Whether an investor can provide instructions to an investment broker or allow their investment advisor to undertake their investment policy on their behalf. Please contact us to learn more about our investing services.

Family Office Investors

Most family offices still cling to an outdated approach to investment management. They pay high fees for active management that fails to outperform passive benchmarks. In addition, many family offices advocate for portfolios that mirror pension fund allocations. They diversify between various asset classes including stocks, bonds, real estate, private equity, and other alternatives. The sales pitch from mainstream family offices is this approach achieves the best risk to reward trade-off.

But for wealthy investors, simplicity and low-cost provide greater benefits. And so the high cost (and complicated) approach taken by pension funds should be avoided.

Our Clients

The wealthy investors we work with don’t fear the daily ups-and-downs of the stock market because they support the idea of a long-term buy-and-hold approach. One that has made them wealthy and provides them with confidence. Whether its by investing in blue chip stocks or by holding real estate over the long-term (or both). The wealthy investors our family office works with value the financial peace of mind that comes with a long-term buy-and-hold low-cost approach.

How does our simple, low-cost approach compare to the high cost approach associated with most pension fund style portfolios? Well, when investors use simple to understand strategies, they have few reasons to pay high fees. This means more money in their pocket (or their charities of choice) and less fees paid to slick financial salespeople. Since, the value of active management (choosing which stocks to buy and sell) is negative. And, we understand that most investors are better off holding index funds or using simple to understand investing strategies rather than paying for active management.

Factor-based investing fits into our philosophy because a passive factor-based approach allows low-cost investors to manage large pools of capital without the burdens of bureaucracy and high-overhead. Since, a rules-based approach to investing avoids discretion. And, its easy to implement and monitor. It doesn’t require much expertise, other than the ability to implement the rules as outlined in a documented investment policy.

Our Approach

The evolution of investing philosophy from indexing through behavioral finance insights to factor-based investing reflects a sophisticated understanding of markets and investor behavior. A simple, low-cost factor-based investing model offers a compelling solution for wealthy investors and one that our family office supports. It leverages systematic, evidence-based strategies to achieve diversified, efficient, and potentially higher-returning portfolios while minimizing the impact of biases and costs.

Investors interested in exploring this approach are encouraged to contact us. Our team can provide a review of your situation, help you document your financial goals, and suggest a tailored investment strategy that aligns with your long-term objectives. Sign up for our free weekly newsletter for more insights or schedule an appointment to discover how factor-based investing can fit into your wealth management process.