A variety of tools can be used in the challenging quest for outperformance. Investors are no longer limited to expressing active views through a manager—they can do so through a range of products, for example, factor-based investments.
Factor-based investing aims to capture specific performance characteristics—for example, more dividend income, higher risk-adjusted returns, or lower volatility—associated with certain securities. Not only can investors access factor exposures through active managers, they can also do so through passive vehicles.
But successful active investing—whether it is through factors, timing, or stock selection—is challenging, and no shortcuts exist that guarantee outperformance. Sure, low-cost managers tend to outperform their high-cost peers, but low cost by itself does not lock in success.¹
Along with cost, another component of successful active management is thorough due diligence—that is, an in-depth examination of the investment management firm, its philosophy, people, and process. Many of us have a long list of questions that we like to torment active management candidates with before we entrust them with our clients’ savings. (My colleagues have explored this topic in the white paper The case for Vanguard active management: Solving the low-cost/top-talent paradox?) Due diligence helps us to understand how well an active manager aligns with our investment objectives.
So do we still need due diligence when we implement factor-based investing through a passive vehicle?
While the relevant questions may change—key-person risk, for example, is less important for a passive vehicle—we still need to understand how well the investment fits with our investment objectives. If our view is that a value tilt will outperform the market over the long term, is our chosen index consistent with this view? Does the exposure of the index vary over time, or is it fixed? Are we getting a pure factor exposure, or is it mixed with other factors?
Just like active managers, factor-based indexes can display a wide range of performance variation—even among investments from the same category. Differences may be due to the investment universe or the weighting scheme, for example. The way a factor exposure is defined by an index can vary too. And, in many cases, factor exposures may be packaged with other exposures, depending on how the investment is implemented. The bottom line is that there is potential for factor-based index investments to experience a range of performance outcomes.
Staying the course is equally important with factor-based index investing, too. While historical data show that factors can achieve specific performance characteristics, it is just as likely that factors can experience long periods of underperformance as well. These periods of underperformance should be viewed in the context of long-term objectives, however, and investors should be mindful to not fall into the trap of reducing factor exposures based on recent poor performance.
Factor-based index investing offers the potential to target and achieve a variety of different investment outcomes. To increase the chances of achieving these goals, investors should keep in mind these three principles: due diligence, patience, and, of course, low costs.
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1 Wallick, Daniel W., Brian R. Wimmer, and James D. Martielli, 2013. The case for Vanguard active management: Solving the low-cost/top-talent paradox? Valley Forge, Pa.: The Vanguard Group.
All investing is subject to risk, including possible loss of principal.