Not so long ago, it was only the big institutions that had access to all the pertinent investing information, but nowadays even the small investment firms can say they are playing at the same level.
In this episode of The Agent of Wealth Podcast, Marc Bautis explains the history of investing and portfolio management along with how and why factor-based investing came to fruition. Looking at aspects such as quality, volatility, momentum, and size, Marc shares how he and his firm utilize the factor investing strategy to best help their clients.
In this episode, you will learn:
- An explanation of factor investing.
- Details about the four main factors used in factor investing.
- What to consider about each factor.
- How Bautis Financial uses this strategy to help their clients.
- And more!
Tune in to get an inside look at factor investing trading.
Bautis Financial: (862) 205-5000
What is a Factor Investing Strategy?
Before we get into a definition of factor investing I wanted to cover a history of investing in general which will help explain how we progressed to utilizing this strategy.
Investing is kind of this black box to a lot of people. A lot of investors think that as advisors, we just put people into passively managed Index Funds like the S&P 500, and then we go sit on the beach for the other 364 days of the year. And on the flip side, some people think that every day we’re day trading their account. If the Dow ticks up or down a point, we’re making massive changes to buy and sell.
10, 20, 30 years ago, only the big institutions had big risk analysis departments and all of this exquisite technology that they used to construct investment portfolios. Some people may say that was an advantage and some would say that it wasn’t really an advantage at all. Over the years, technology has improved so much that even a smaller firm like ourselves are on a level playing field with the big Wall Street firms.
We have institution quality technology and the data has become easy to access and analyze.
When we start working with someone, we don’t just slap some investments into an account for them. We have to look at the context around how we are managing it, what they are trying to do. Are the funds going to be used for retirement and they won’t be accessed in the next 20, 30, 40 years? Or do they want to save money and they want to use it to purchase another house and in 5 years? I’m using two high level examples, but it’s really trying to figure out what context they’re trying to save and what they’re trying to do.
You’ve got different stops along the way, but the bottom line is that you want to get to your final destination and each person’s route is a little bit different.
The investments are obviously a big piece of it, because that’s what helps drive to get to your goals, but it’s not the only thing. Everything we do, we have to make sure it’s tax efficient and we look at how it falls under their plan of their big picture.
They have other team members that you help coordinate like a tax advisor, or an attorney that you guys are working with as well, because everybody’s situation is different. I love the fact that you take all that into account and instead of investment management, it’s more like client management or relationship management.
I’m a big proponent of having a team structure in place. Some companies or even people will claim they do everything you want: taxes, investments, financial planning. The reality is that all this stuff is complicated. I don’t know how many pages the IRS tax code is, but it’s a lot. It’s impossible to be an expert at that, investments, and financial planning.
So you want to have a team established. You want to utilize and make sure all those people on the team are on the same page with looking out for what’s best for you: what’s the best tax strategy, how does that fit across investments,
and how does it all map towards making your life matter as well as hitting your financial goals? I’m 100% in agreement with you that having that team structure in place is definitely a good thing. I think that anybody would agree with that. Do you want one person doing a mediocre job at all of those different pieces, or do you want a team where each person is an expert in that individual field? As far as the investment piece, we’re always looking at it from the risk and return perspective; meaning that is there a way that we can take less risk with our investments and achieve the same return? Or is there a way that we can take the same risk, but have a higher return than the benchmark that where we’re comparing against? Another point of confusion is that a lot of investors will compare their portfolio with what the S&P 500 does or what the Dow does, and partly that’s because that’s what you hear most of in the news.
But, that’s not necessarily an appropriate comparison because that’s just a bucket of 500 U.S. large cap stocks. Your strategy might be different. You might be looking to generate income, you might be 80-years-old and trying not to run out of money.
You might be younger and be able to be more aggressive than that. We assign a benchmark to every portfolio that we’re managing, and it’s really just to compare or measure and see how are we doing on that risk and return perspective.
Just before I get into the factor investing piece of it, I just wanted to cover four things that I see a lot that trip up investors with their investments.
Four Things That Trip Up Investors
Lake of Diversification
The first one is lack of diversification. We hear all of the time that diversification is good, but you always want to ask: why is it good? It’s good for a couple of reasons. One, it will smooth out your returns. I don’t think anyone likes volatility when looking at their monthly statement. I’m sure they like seeing it go up a lot, but they don’t like the reverse when they see the big drop. Diversification can help smooth that out. Over time, a lot of asset classes, will go up.
But, if you look at a year-by-year breakdown, you’ll see that they can swing wildly. When I say asset classes or different investment types, here’s what I’m really talking about. On the stock side or the equity side, there’s large cap stocks, which are like your big, well-known mega companies.
There’s mid cap stocks and then there’s what’s called small cap stocks; they’re just based on how big a company is measured by their share price and the number of shares they have outstanding. Then, there are those same breakdowns on the international side with foreign stocks and also another breakdown called emerging markets, which are still your international companies but not as well-developed economies.
If you look at it year-by year, you’ll see that the returns for each of these different asset classes are really different. One year, large cap U.S. stocks might have the highest return and in the next year, it might be towards the bottom when emerging markets might have the highest return. Two recent examples that we can point to for that are: in the decade of the 2000s (2000 to 2010), the S & P 500 actually didn’t really increase much at all. It was one of the first 10 year periods ever where there wasn’t a gain. Partly, the reason for that was there was the .com bubble bursting in 2000 and then we had the 2008 financial crisis.
If you were invested solely in the S&P 500, you would have been pretty unhappy if your accounts didn’t go up in value from over a 10 year period. However, emerging markets and some international stocks were up 12% a year during that period of time. So, that’s where the diversification comes in.
On the flip side, over the past couple of years, emerging markets and international stocks haven’t had nearly the same return that U.S. large cap stocks have seen.
What else trips up the investors? The second thing -and you see this a lot is performance chasing and then making decisions emotionally on your portfolio. I see this a lot, and what this really leads to is buying high and selling low.
When things go up, you get more confident and you decide to put more money in or to be more aggressive. Then, when there is a pullback, everyone thinks things are only going to get worse. Let’s take the money out now from the market, cut the losses, and then when it hits the bottom, we’ll come back in.
The reality is that it’s not really that simple to do. There’s been very few people who have been successful timing the market. Even with the people that have had significant gains, they can say that a lot of it can be attributed to luck rather than an actual skill to market timing.
Even worse, I’ve seen people add money to their 401k and they just don’t do anything with it; it just sits in cash in a money market fund for years, and they don’t even realize it. This sets the framework and leads us into factor investing and how it can benefit you.
We’re really trying to take the same amount of risk and get a better return than our benchmark or take less risk to get the same return This whole factor strategy or factor investing concept stemmed from historical research on what drives performance.
This research came up with four main factors that exhibit outperformance which in the industry is called “alpha”.
4 Factors that Drive Outperformance
The first one is what’s called a quality factor. You want to add companies to your portfolio that generate earnings consistently. You don’t want a company that has great earnings one year and negative earnings that the next year. You want companies that use a lower amount of leverage. In the event something bad happens with the company, having lower leverage is definitely a good thing. To select “quality” companies you want to look at their different metrics of their company like revenue and dividend growth. Iis it a certain amount over time? Have they been increasing their dividends over time? A couple of companies that fall under the Quality factor are Apple, Johnson and Johnson, and Mastercard. They are not investment recommendations, but just examples that fall under this category.
Factor number two is Volatility. The goal with volatility factor is to select investments that generate that similar market return while taking on less risk. I think everyone can kind of understand this one. You don’t want a stock where the price is up 10% one year, down 10% the next year, up 5%, down 20%, up 30% and so on. You want a stock that behaves like the market does; but there’s less risk and less fluctuations in the stock price.
If the gains go up as smooth as possible, it’s definitely a lot easier to handle. What are some examples? Insurance companies fall under this category: Chubb, Aflac, Allstate. A lot of the reason why they fall in the low volatility factor is that they have customer premiums that they collect and they just keep collecting them and collecting them.
So, it’s pretty smooth. Most people, even if the economy doesn’t do as well, they’re not going to discontinue their auto insurance or their home insurance. They call these “cash cows,” where they just keep generating premiums, generating revenue, year after year.
The third one is momentum. If the trend of a stock of the market is going up, don’t fight it; go with it. This one’s very interesting because now, the markets are at highs and a lot of people that I’ve talked to are nervous about that. They don’t want to invest more, or they want to take what they’re investing in, and pull back some of the risks.
Conversely, the, statistics show that when a stock hits a new high, there’s a better chance of it hitting another new high than there is actually of it coming down.
I think people are starting to realize at a high, if you look at where we are in the market cycle (and we’ve had a bull market for a number of years), but just because it’s at a high there, it doesn’t mean that it’s going to come back and there is a good chance that it’s going to hit a high again.
Since 2013, we’ve had 223 new all time highs in the S&P 500 and I definitely have received calls from 2013 to now where someone would say: we’re at a high, I think the market’s going to come down, let’s pull some money out. And if you would have done that, you would have been in worse shape than you would have been if you would’ve just held onto it.
That’s why it’s really hard to do, because you have to be right when you take the money out and then you have to be right again on saying well it looks like we’re on a downfall, it looks like we hit bottom. Let’s put the money back in.
Being right twice is extremely difficult, if not impossible to do.
The last one is size-the size factor. It states that (small cap companies) smaller companies over time will do better than large cap companies. The reason for this is pretty simple. Let’s say you take the stock prices generally are driven by how well a company is growing.
Are they increasing their revenues? Are they increasing their income or their earnings? It’s easier for a smaller cap company to increase revenues, increase income than it is for, for a larger cap.
And I’ll give you an example; let’s say we have a company that is generating $50 million a year in revenue. For them to get to $100 million a year in revenue, it’s probably going to be quicker than if we had a $50 billion company try to get to $100 billion. What the size factor is claiming is that smaller companies have an advantage just because they can grow their revenues and income faster than a larger company can.
Factors Behave Differently Over The Economic Cycle
The economy is always cyclical and is always in either an expansion, peak, contraction, or trough.
Economic cycles don’t have specified start and end times. This bull market has been a long one. But just because it’s been a long one does not mean it is going to stop tomorrow. It just means that at some point there will be a pullback and there will be a contraction in the economy.
During a recovery you want to focus on the Size Factor because those are the companies that generally can take advantage of the positive momentum in the economy best.
You also want to look at the Momentum Factor because if the economy is humming along, you want to go with the month momentum and not fight it.
If there is a slowdown in the economy you want to look at the Minimum Volatility Factor.
We still don’t want to be a market timers and make calls on peaks and troughs, but we do try to make small shifts in the portfolios with these factors.
When you’re talking about these factors, how do you plan the investments for them? There are a couple of different ways that you can do that.
The first is by adding ETFs or exchange traded funds to the portfolio.
We can also add the individual stocks of companies that exhibit a certain factor.
Everything we do we want to make sure it’s in the most tax efficient way possible and with the lowest cost.
We use TD Ameritrade to hold our client’s accounts and they (along with some of the other financial institutions) have eliminated trading commissions.
This has given us the ability to utilize a strategy called Direct Indexing. We can take an index like the S&P 500 and instead of buying a fund that contains all 500 stocks in the index, we can invest directly in the company’s in the index and exclude ones that don’t pass our filters. As an example we may want to only invest in companies that are growing their revenue at a certain clip. So out of the 500 companies in the index maybe only 100 meet our criteria.
This allows us to be more tax efficient, because we can harvest losses individually versus if we could only buy or sell the entire S&P 500 fund.
It allows us to do the reverse of mutual funds which are tax inefficient because you are at the mercy of a fund manager who you have no control over what he buys or sells inside of the fund. And what we’ve seen over the past couple of years is at the end of the year, these investors who are investing in mutual funds get these enormous capital gains.
And that’s a little bit of info into factor investing, one of the strategies we use to manage investment portfolios.