Look at the stock market, and you’ll see that certain stocks often do better than others. Technology stocks have been the standout performers over the past 10 years. Healthcare stocks, while less obvious, have also done very well.
Research has found that certain types of stocks have also done better than others. Smaller companies’ stocks, for example, have outpaced those of larger companies. In the academic literature, characteristics like this, that are correlated with outperformance, are known as investment “factors.” More than 100 such factors have been identified. Below is a brief history of factor investing and thoughts on how you might—or might not—incorporate factors into your portfolio.
Research on factors began in 1992. Eugene Fama and Kenneth French, colleagues at the University of Chicago, discovered two factors that had a clear correlation with outperformance: small-cap and value stocks. This research was broadly accepted, in large part because it was supported by intuition. It’s easier for smaller companies to grow more quickly, percentagewise, than larger companies. And it makes sense that value stocks, which are cheaper, have more room to appreciate than those that are already more expensive.
Factor investing is far from perfect, though. The Fama-French factors have sometimes lagged for long stretches. Value stocks, in fact, have lagged their growth peers by about 75 percentage points over the past 10 years. Similarly, small-cap stocks have an uneven track record. Last year, when the S&P 500 index of large-cap stocks dropped 18%, smaller stocks lost 26%. Factor investing, it turns out, requires patience—lots of it.
Even if you had the patience to stick with an investment factor over the long term, research has shown that good ideas often sow the seeds of their own demise. In a well known paper from 2012, researchers David McLean and Jeffrey Pontiff looked at this question. Their study was titled, “Does Academic Research Destroy Stock Return Predictability?”
McLean and Pontiff examined dozens of stock market factors. What they found is that factors tend to have a shelf life, with performance advantages dissipating over time. Why? When a new factor is identified—and publicized—other investors will tend to pile into that investment. That can drive up its price. If enough people do that, the opportunity to outperform with that investment will fade because the price has already risen. Investors talk about an advantage being “arbitraged away.”
The lesson for investors: Factors aren’t permanent. If you do decide to tilt your portfolio in favor of one factor or another, I wouldn’t go too far—because what worked yesterday might not work tomorrow.
Another obstacle to implementing factor strategies: They tend to be tax-inefficient. Because factor investing involves picking and choosing stocks, it can require frequent trading, and that trading can carry tax implications. Thus, if you choose to incorporate some factors into your portfolio, try to do it in a tax-deferred account.
Another oddity of factor investing: Certain factors stand in direct contradiction with one another. Momentum stocks, for example, are stocks that have recently been trending higher. They’ve been shown to exhibit outperformance. But so have value stocks, which are stocks with lagging share prices. In other words, they’re the opposite of momentum stocks, and yet, they’ve also exhibited outperformance. This inherent contradiction doesn’t make a lot of sense, and that’s a reason many investors are skeptical of the entire idea.
Even professional investors who work to exploit factors don’t find it easy. In The Man Who Solved the Market, Gregory Zuckerman looked at Renaissance Technologies, the hedge fund with arguably the best track record in the industry—returning an average of 39% per year for 30 years. But that success was hard won. Even with all its expertise and resources, a Renaissance employee once commented that only 50.75% of the firm’s trades were successful—an awfully thin margin.
In the end, after Renaissance fully cracked the code on factor investing, the firm returned all outside shareholders’ money. So even if you wanted to invest in Renaissance today, you couldn’t. The bottom line: These strategies are extremely difficult to implement. And the firms that do it best aren’t easy to access.
In fairness, you don’t need to build a Renaissance-like computer model to identify winning corners of the stock market. As I noted earlier, certain industries have demonstrated strong performance, and it would be easy to buy index funds that covered those specific industries. So it might seem like an easy solution would be to build a portfolio that simply overweighted these winning corners of the market.
While that might seem logical, there are flies in the ointment with even this simple idea. Perhaps most significant is that sectors move in cycles—sometimes outperforming and sometimes underperforming—and these cycles are erratic. Consider the energy sector. Over the past 20 years, the oil market has swung between two extremes. In the late-2000s, many believed in “peak oil,” the idea that the world was running out of oil. Oil prices peaked in 2008 at $145 per barrel. In the years after the financial crisis, though, electric cars became more of a reality, and oil prices sank. But still, it hasn’t been a straight line.
Last year, largely because of Russia’s invasion of Ukraine, oil prices rose, and the energy sector was the top performer in the S&P 500—gaining 67%. This year, however, despite the ongoing war, prices have moderated, and year-to-date, energy is the worst sector—down 7% while the overall market is up 8%. In other words, you might have a long-term thesis on an industry—and you might be right—but in the short term, things could easily go in the other direction.
It’s not just energy. Every sector has its own dynamics. Banks, for example, are steady money makers in good times. But as we’ve seen this year, shifting interest rates (combined with mismanagement) can drive them into insolvency. Healthcare stocks have been the second-best performers in the S&P 500 over the past 10 years. But the government and insurers hold so much sway that it’s hard to know whether these stocks will be as profitable over the next 10 years. No sector is flawless.
For these reasons, it’s difficult to know which corners of the market will be leading the way at any given time. That’s why, in building a portfolio, I recommend trying to stick closely to a total-market approach. You could include some small factor overweights—personally, I include small-cap and value—but I would do that only in the most modest way. Jack Bogle said it best: “Don’t look for the needle in the haystack. Just buy the haystack.”
