In 1900, the noted physicist Lord Kelvin declared, “There is nothing new to be discovered in physics now.” In the annals of inaccurate proclamations, this one stands out. Just a few years later, Einstein published his Theory of Relativity and, in the following years, proceeded to upend many of the scientific world’s most long-held and deeply-held beliefs.
Seventy-six years later, the world of personal finance witnessed a similarly inaccurate prediction. When the newly-formed Vanguard Group launched its first index fund, Edward Johnson, then the leader of Fidelity Investments, derided and dismissed this new approach to investing. He is quoted as saying, “I can’t believe that the great mass of investors are going to be satisfied with an ultimate goal of just achieving average returns.” Johnson wasn’t alone in his criticism; others called the notion of an index fund “un-American.” But like Lord Kelvin, these critics got it wrong. Indexing took off in popularity, and today Vanguard is twice the size of Fidelity.
Inaccurate predictions, with the benefit of hindsight, are always amusing, but they should also give us pause. Today, virtually all of the evidence, and most industry experts, favor index funds as the best way for individuals to invest, and I agree with them. But we should heed the lesson provided by the Kelvins and the Johnsons and not become too comfortable in our beliefs. We should always keep our eyes — and our minds — open to new approaches.
In fact, one approach, called “factor investing,” has been gaining in popularity and is worth understanding.
The premise of factor investing is entirely logical: If you examine the stock market, you’ll find that there are certain factors that will cause some types of stocks to do better than others. Among the most well known factors, for example, is the size of a company. Specifically, small companies’ stocks tend to outperform big companies’ because they are often able to grow faster, on a percentage basis, than their larger competitors. Another well-established factor is valuation: Cheaper stocks tend to outperform more expensive stocks because, when you buy an inexpensive stock, you are buying at a discount, providing more opportunity for profit later. Both of these factors make intuitive sense to me, and that is why the portfolio that I manage for you includes both small-company and value-oriented funds.
While size and value are the two most well known factors, they aren’t the only ones. In fact, a recent study attempted to explain Warren Buffett’s success through the lens of factors, and they highlighted another factor: quality. What the authors found was that, in addition to cheap stocks, Buffett favors high quality companies, defined as having (1) above-average profitability and stability of profits; (2) above-average growth; and (3) a below-average debt load.
In other words, the authors believe, a large part of Buffett’s success can be boiled down to a simple formula: buy good companies at cheap prices. In a way, it seems simplistically easy. So, with this formula in hand, should you shift your investments over to mimic Buffett?
No, not yet, but I also wouldn’t make the mistake of dismissing the concept either. The primary reason why I would take it slow is that this area is still very new and is still making the transition from theory to practice. Some factor-based funds have as much as five years of history, but most are much newer. In fact, Vanguard didn’t launch its own factor-based funds until earlier this year, and they are all still very small. So, the idea needs a little more time to mature and best practices to develop. For now, I would bet only on the most well established factors — size and value — but this is an important trend to monitor, and I will keep you posted as it develops.