THE NOTED PHYSICIST Lord Kelvin reportedly declared in 1900, “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 longest standing and most deeply held beliefs.
The world of personal finance witnessed a similarly inaccurate prediction 76 years later. 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, today Vanguard is twice the size of Fidelity—and Fidelity itself is now making a big push into index funds.
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.
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 historically have caused 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 those of 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 gains later. Both of these factors make intuitive sense to me.
While size and value are the two best known factors, they aren’t the only ones. Research has lately turned up a slew of factors associated with superior market returns. In fact, a recent study attempted to explain Warren Buffett’s success through the lens of factors and highlighted another one: quality. What the authors found was that, in addition to cheap stocks, Buffett favors high quality companies, defined as those having above-average profitability and stability of profits, above-average growth and 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 absurdly easy. Now that we know the purported road to wealth, should you shift your investments over to mimic Buffett?
No, not yet. But I also wouldn’t make the mistake of dismissing the concept. This area is still very new and is still making the transition from theory to practice. Some factor-based funds that draw on the new research, such as AQR Large Cap Defensive Style Fund (AUEIX) and iShares Edge MSCI USA Quality Factor ETF (QUAL), have as much as five years of history. But most are much newer. In fact, Vanguard only launched its own factor-based funds—including a multifactor fund—earlier this year and they’re all still very small. The idea needs a little more time to mature and for 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. I, for one, am watching it closely.
Adam M. Grossman’s previous articles include Any Alternative, Buy What You Know and Staying Focused. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.