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5 Traits of Factor Investing, or the Wave of the Future
The Wall Street Journal recently profiled factor investing, which is my candidate for what well diversified portfolios will look like in the future.
 
However, I don’t expect this idea to take the world by storm any time soon, since most of my discussions with others on this topic end with blank stares and one or more people nodding off. 
 
I do think we’ll see the investing world slowly but surely moving in this direction. Here are five things to know about factor investing before you consider implementing such an approach:

Limited Options
At this point, the options for most individual investors are somewhat limited. I would argue that one of the most effective ways to diversify across factors is to implement a portfolio similar to what Bill Bernstein outlines toward the end of the Wall Street Journal article or what my colleague and good friend Larry Swedroe recently discussed with the New York Times. However, keep in mind that even these types of strategies still have substantial exposure to the overall equity market and will likely be down significantly when the overall equity market is down.

Not for Everyone
Not everyone should implement these types of portfolios. After all, small-cap and value stocks are relatively small proportions of the world’s equity markets. Further, some investors already have exposure to certain investment factors through their job or business. A small business owner, for example, may not need more exposure to the small-cap stock factor because such risk is already embedded in the business.
 
Some Factors Still a Mystery
Some factors are better understood than others. The equity premium — the tendency for equity investments to provide higher returns than safe fixed income — is an example of a “factor” that is well understood: most investors understand that investing in equities is risky and that they should expect to be rewarded for doing so. On the other end of this spectrum is momentum, the tendency for stocks that have done relatively well in the recent past to continue to do well. This strategy has historically generated sizable rewards, but no one really understands why it should generate substantial returns.
 
Taxes Are a Concern
Factor-diversified portfolios can be more tax inefficient than traditional portfolios. This is one reason why I expect that substantial movement toward factor diversified portfolios will first occur with tax-exempt, institutional investors. Nevertheless, this doesn’t mean that individual investors shouldn’t consider it, but they should be aware of the tax consequences and seek out ways to implement the approach in a relatively tax-efficient manner.
 
Tracking Error
Almost all investors benchmark their portfolio against something, such as the Dow Jones Industrial Average, S&P 500 Index or their friends’ portfolios. I can almost guarantee you that factor-diversified portfolios likely won’t look or behave like anything that you track. This tendency is called tracking-error risk. In fact, I think this is a legitimate risk of the strategy and why I expect that this approach will continue to generate attractive risk (in the traditional sense) and return characteristics over the long term. Many investors simply don’t have the discipline to stick with prudent investment approaches over the longer term if those approaches subject them to the risk of substantial underperformance of well-known benchmarks, colleagues or their friends in the shorter term.

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