Starshine 3 Satellite. Source: NASA
Factor investing is a different way to slice and dice a portfolio. You may have a bond portfolio made up of Government, Corporate, and Foreign Bonds. But the returns they generate come from different factors: their length, their default risk, and the risk of their being called – their duration, credit, and convexity.
In the same way, a stock portfolio can be examined from multiple angles: where the companies are located is one axis – US, Developed Markets, Large Emerging Economies, Frontier Economies – various factors are another – size, value, quality.
You could add a third axis – industry – to this view, and possibly more. It’s hard to visualize more than three dimensions, but with modern computing technology it’s possible to make ever more granular distinctions, looking at companies from multiple angles.
In a lot of ways, factor investing is like Rashomon, the ground-breaking 1950 Japanese movie that tells the story of a samurai’s murder from multiple perspectives, in succession. We see a woodcutter’s perspective, the bandit’s perspective, the samurai’s story, and his wife’s story – all of which differ in some key elements. By the end, you end up wondering whether it’s possible to get at the at all. Everyone has a “perspective.”
But the truth is out there. There are “brute facts” that must be explained. Companies make sales and generate earnings; their stocks go up or down; bonds either pay off at maturity or default. All the assets, combined in a portfolio, generate returns. The assets are tied to an underlying economic reality. Factor investing is just a different way to visualize the various risks to this reality. By taking uncorrelated risks, in a balanced way, we can improve our portfolios’ performance.
Factors can be like consumer choices: too many, and we get paralyzed. But used correctly, they can lead us to higher returns with lower overall risk. There’s nothing confusing about that.
Douglas R. Tengdin, CFA