Does factor investment work?
Now those tireless investigators of all things financial [specifically, in this case, Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School, in an article in the Journal of Portfolio Management] have investigated the what and the why of factor investing.
It does seem that 40 years of share price history supports the theory – but not always reliably. There are years when these factors do not deliver.
The ‘why’ could yet prove a question without a suitable answer. Are the higher returns associated with certain factors the reflection of greater risk?
Smaller stocks are more expensive to manage, and much less liquid and so riskier in a downturn. Value stocks may look cheap, but that valuation may also reflect a more dangerous business environment.
Or perhaps those higher returns have more to do with the behavioural biases of the managers. Some managers are quicker to discern that business conditions have changed, and a company’s outlook has developed for the better. As others follow these leaders, so momentum builds. Hence crowd-following tendencies can lead to overpricing of high-volatility shares, with their relatively less exciting opposite numbers benefiting from a return to investment sanity.
The important question
Before private investors jump into the Oeics and ETFs that are promoting such methods, they need to ask themselves just one question. Does such an investment style protect their hard-earned and absolutely essential capital? More specifically, perhaps, did this investment style protect them when markets turned mad at the beginning of February?
The brutal truth of investment mathematics never changes – a sudden fall in a share price can result in a 50 per cent loss of capital, which then requires a doubling of what remains merely to get back to the original starting point. Moreover, these temporary market shocks seem to affect prices in a perverse way: the share that has fallen by 50 per cent never seems to be the one that recovers. The reorganisation of a portfolio in acceptance of the new market reality brings further risks of its own.
Do capital gains exist?
Despite investment managers’ promises to the contrary, there is no such thing as a ‘capital gain’, although there are certainly ‘dealing’ gains. Report after report shows that it is compounded dividends that produce the capital gains of a portfolio, while compounding, in this context, arises from a portfolio managing to avoid losses.
The lower the loss, the greater the overall gains over the life of the investment. Indeed, this finding was one of the most important of the previous studies conducted by Mr Dimson and Mr Marsh some decades ago.
Investors have a choice. They can be ‘dealers’ – buying and selling individual shares or bonds as the mood takes them – or investors. If the latter, then their choice is between active or passive investment in the markets of their choice – domestic or global, blue chips or smaller companies, generalist or specialist, consumer markets or technology, or as many sectors as fund managers can dream up.
But whatever the choice, stockmarkets are genuinely influenced by emotions, politics and economics. Prices will move up and down, unpredictably and often unexpectedly, and the reasons for their doing so are difficult to discover, even after the event.
Investors are always at the mercy of market movements, so market statistics remain a never-ending source of delight for statisticians, and frustration for managers and investors alike.
Risk versus reward
The primacy of protecting capital has always discouraged individuals from risk taking because, whatever it may mean to market professionals, risk to individuals means loss. For most, that loss could not easily be replaced.
The rich had established their place well before the invention of the computer, and looked to professionals to manage their free capital and produce an income for them. Initially, that income was from land or property but, following the advent of the industrial revolution, it also came from the interest paid from the bonds of governments, or large-scale enterprises such as railways.
For two centuries the principle purpose of investment was the purchase of a risk-free income: if desired, some element of risk would be accepted if that risk promised an increasing income over time.
The skill was in putting together a portfolio that heightened the return but kept the risk low. This began to change from the 1950s onwards as computer analysis enabled the development of stockmarket theories based on analysis of share and bond prices. But when the bad times come, it is yield that counts, for the certainty of income helps shield shares and portfolios from the worst of market swings.
The “dividend heroes” compiled by the Association of Investment Companies prove the real possibility that a portfolio of shares can outface market turbulence.
February’s market tantrum suggests that a 10-year bull market is nearing its end, or at least foreseeing difficult times to come. Economically, other than the UK, the world seems set fair – but politically it is full of risk, and financially there is much to fear.
Quantitative easing (QE) is ending and probably going into reverse: if QE kept markets content will QT, or quantitative tightening, do the reverse? Central banks are aware that inflation is picking up, and that their main task remains to keep it under control. Market liquidity is in danger from central banking mistakes, and both bond and share markets are at levels that should frighten investors.
Investors need to generate income, and as recent articles have shown, the best way to achieve this is through the purchase of investment trust shares. If February worries private investors, that is no bad thing. They should increase their cash holdings – a 30 per cent cash holding becomes more like a 60 per cent holding if equities fall by 50 per cent.
That will be a great position to be in at the time, if it happens, since buying at the right [or low] price is one certain guide to investment success. And if the bull market in equities continues to roar on, you will not be overexposed – but you will at least be profiting while still sleeping well.
