The latest fad in investing is “Factor Investing”, according to the August edition of Financial Adviser Magazine. Like a bad fad diet, these investment methods come around every few years (factor investing dates back to the 1970s[1]) and claim to have found a method for stock picking that will win every time. Factor investing relies on five genuine factors which are, according to academics, Value, Quality, Momentum, Size, and Volatility. When it comes to understanding investment methodologies, I find it helpful to imagine them along a line:

I am an active investor. Does this top-down investment methodology work? I don’t think so; as an active investor with a bottoms-up approach, I believe that Factor Investing makes the same mistakes as asset allocation and Modern Portfolio Theory. Let us examine and compare Factor Investing with my bottoms-up approach.

Like asset allocation, Factor Investing aims to diversify a portfolio in a way that would lessen the hit should a market downfall, like 2008/09, happen or to beat the market in an upturn. However, unlike asset allocation, Factor Investing does not focus on diversifying merely between stocks, bonds, and commodities, but on several factors that factor investors believe indicate a tendency to out-perform the market. A factor investor balances Value, Quality, Momentum, Size, and Volatility to decrease risk in a portfolio in the same way a financial planner would balance stocks, bonds, and other investment vehicles. Factor investing is rules-based, not decision-based. You choose a sector of the economy and apply your rules.

So, does Factor Investing work? Popular theory says it does, but the facts dispute this. Cliff Asness, co-founder of AQR Capital Management and one of the top thought leaders in Factor Investing, has said that “factor investing strategies have been disappointing.”[2]

Alternatively, bottoms-up approaches focus on picking the correct company. Warren Buffett said, “Buy a stock the way you would buy a house. Understand and like it such that you’d be content to own it in the absence of any market.” One good company can do a great deal to raise and maintain the value of a portfolio. A good example of the success of this methodology is to compare two grocery stores from the 1950s: Great Atlantic and Pacific Tea (A&P) and Kroger. Although in the ‘50s, Kroger was only about half the size of A&P, in the 1960s they began laying out a foundation of transition which was critical in the changing market. In the next twenty-five years, Kroger grew 10-times the DOW and 80-times A&P’s stock.

The company which was clearly the “safer” investment from a 1950’s perspective proved to be the weaker investment over the next thirty years. The rules that Factor Investing relies upon would not have found that investment until it was too late, and the money had been made. I believe the way you have the best chance to “beat the market” is to find the right companies and buy the stocks in those companies – otherwise known as bottoms up active investing.

[1] Riquier, Andrea. “What is factor investing?” MarketWatch. Accessed November 11, 2019 https://www.marketwatch.com/story/investors-should-get-smart-about-factors-2019-09-27

[2] Gittelsohn, John. “Cliff Asness Says Factor Investing Has Not Performed Well.” Bloomberg. Accessed November 11, 2019 https://www.bloomberg.com/news/articles/2019-05-09/aqr-s-cliff-asness-says-factor-investing-has-not-performed-well