The Traditional Divide
Passive investing has gained tremendous popularity over the last decade, and for good reason.
It offers a straightforward approach: track a market index like the S&P 500 (US stocks) or FTSE 100 (UK), keep costs low, and maintain broad diversification to reduce company-specific risk. The underlying philosophy is that markets are generally efficient, making it difficult to consistently outperform them.
Active investing, on the other hand, involves fund managers selecting individual stocks, bonds, or other assets in an attempt to beat the market.
While this approach offers flexibility and the potential for higher returns, it comes with significantly higher fees (due to extensive research and portfolio management costs) and the challenge of consistently making the right calls.
The evidence largely favours passive investing over the long term.
The widely quoted SPIVA (S&P Indices vs Active) reports (link here) shows that most active fund managers underperform their benchmark indices most of the time.
However, this doesn’t tell the whole story. If you were to run the same analysis for passive funds, you’d probably reach a similar conclusion, as most experience some degree of ‘tracking error’ (i.e., slight underperformance compared to the index they’re tracking) due to trading costs and fees. As such, the outperformance of passive over active is probably overstated.
And there’s a valid concern for passive funds that they are becoming increasingly concentrated in a small number of stocks - particularly in the US where the Magnificent 7 tech behemoths now represent around a third of the benchmark S&P 500 index.
Alas, ‘What if there was a way to combine the best of both approaches?’
Enter factor-based investing – an alternative strategy that bridges the gap between these two approaches.
It maintains the cost efficiency and wide diversification of passive investing while incorporating factor ‘tilts’ designed to enhance long-term returns and reduce risk, a la active investing.
What is Factor-Based Investing?
Factor-based investing is a strategy that focuses on specific characteristics of stocks that have historically been linked to stronger long-term returns. Extensive research, particularly by economists Eugene Fama and Kenneth French, has highlighted three key factors that tend to drive investment performance:
- Size – Smaller companies have generally outperformed larger ones over time. They are often less well-known, more agile, and have greater growth potential.
- Value – Value investing involves buying stocks that appear underpriced relative to their financial health (such as earnings and book value). Historically, these "bargain" stocks have delivered better returns than their more expensive growth-stock counterparts. However, value investing has faced challenges in recent years due to the strong performance of big tech stocks.
- Profitability (or 'quality'): Companies that consistently generate high profits tend to perform better than less profitable businesses. This factor has remained strong even when the others have experienced rough patches.
The Long-Term Case for Factor Investing
The numbers supporting factor investing are compelling. Looking at US stock market data:
- Since 1928, small-company stocks have returned an average of 11.9% per year, compared to 10% for large companies.
- Value stocks have historically outperformed growth stocks, delivering 12.5% per year versus 9.5%.
- Highly profitable firms have averaged 11.8% annually, compared to 8.0% for lower-profitability companies (this data set starts from 1964).
*Source: Dimensional - Performance of the Equity Premiums
When these factors are combined, they have historically delivered an extra 1-1.5% per year in returns compared to the overall market. While this might not seem like a huge difference, over decades, it can significantly boost investment growth.
When investing, your capital is at risk. The value of your investment (and any income from them) can go down as well as up, and you may get back less than you invested, particularly where investing for a short timeframe (we normally recommend a horizon of at least 5 years). Neither simulated nor actual past performance are a reliable indicator of future performance.Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.
Expect Bumps Along the Way
“60% of the time, it works every time” [Brian Fantana]
As with any investment approach, factor investing does not produce steady, guaranteed outperformance year after year. There will be stretches—sometimes lasting several years—where certain factors underperform.
This has been the case recently. As per the chart below, which shows the 5-year rolling returns of the three factors in the US, small-caps have experienced some modest underperformance over the last few years (they’ve fared better in other geographies), whereas value stocks have been out of favour for some time. Thankfully, the profitability factor has ‘come to the rescue’, delivering steady outperformance to offset much of the other factors’ weakness.
One might reasonably argue that this strategy continues to be effective because these factors don't always work. If the outperformance were constant and predictable, it would be more widely adopted, and the opportunity would disappear.
Risk Management Benefits
Factor investing offers more than just return potential.
By naturally reducing exposure to overvalued sectors and stocks, it provides an important risk management function. This is particularly relevant in today's market environment, dominated by the "Magnificent Seven" technology stocks.
While these companies may continue their strong performance in the near term, history suggests that exceptional profits typically attract competition that eventually erodes their advantage. Factor-based strategies maintain exposure to these growth stories but at more moderate levels. For instance, while the Magnificent Seven currently represent about 19% of the global stock market, factor-based strategies typically maintain closer to a 10% allocation.
Final Thoughts
Factor-based investing can offer a compelling middle ground between traditional active and passive approaches.
It combines the systematic, low-cost nature of passive investing with well-researched return drivers that can enhance long-term performance.
Factor-based investing deserves serious consideration for investors seeking a disciplined, evidence-based approach beyond simple index tracking without the high costs and uncertainty of active management.
It remains our preferred approach.
Happy Thursday!
