Investors are growing impatient with the latest stock market rally. But a downturn would not make anyone happy either. Therefore, we have a dilemma. Do you cash out and miss growth potential? Do you …
Investors are growing impatient with the latest stock market rally. But a downturn would not make anyone happy either. Therefore, we have a dilemma. Do you cash out and miss growth potential? Do you buy more despite the elevated stock prices? Should you hunker down with more bonds even though rising interest rates would hurt your returns?
Perhaps the answer is beyond your traditional thinking. Yes, asset allocation works over long periods of time. However, it works best if the investor does not try and second-guess the process. For those of you who need more, you can consider factor-based investing.
This is not a new concept. Eugene Fama and Kenneth French first wrote about this in 1992 when they identified that the size and value of stocks are good factors to apply to investing. You may have heard the term "Smart Beta," which is largely built on the factor-based concept and has grown in popularity recently. Concepts like these only seem to come out of the woodwork when investors are searching for something more enticing than their normal allocation. There is no assurance that factor-based investing will work better than anything else, but the historical statistics are compelling and worth a look.
The concept is that you can garner better diversification across domestic equities by selecting certain factors found to drive returns. Factor-based investing is mainly focused on equities and may not give you much exposure to traditional diversification that may also include bonds and commodities. Because different factors can be in and out of favor at different times, you have lower correlations within the portfolio. This is where the diversification benefits come into play.
For example, for the value factor, you would select stocks based on metrics like price-to-earnings and price-to-book alone. Then by adding a tilt toward smaller-sized companies, you gain exposure to the size factor. Adding another group of stocks based on price momentum and yet another on low volatility or risk and you have a portfolio exposed to four factors, all with different attributes. The momentum stocks will generally take advantage of stocks performing well in growth cycles. The low-risk stocks will tend to be more defensive. Usually small-company stocks behave very differently than large companies and undervalued stocks appear to have more upside potential.
Now you need to add the discipline. Nothing works quite like rules when you are investing other people's money. It is extremely important to monitor and adjust the portfolio as these stocks shift in price, size, momentum and risk. This is not a buy-and-hold strategy but rather an active process that needs to engage the investor to act quickly and without emotion when the numbers call for a shift. It is best if IRA assets are used in this strategy to avoid the tax complications associated with short-term changes to the portfolio.
Factor-based investing is not for everyone, and it is certainly not for all of your assets. It appears to benefit from active management on top of your core allocation that is designed to meet your goals. This type of approach incorporates a more concentrated portfolio which may debunk some old myths about seeking portfolios that hug a benchmark, or the more holdings, the better. Adding more stocks to a portfolio does not necessarily improve diversification. And our research has shown that consistent outperformance is closely tied to a rules-based process where the portfolios look quite different from a benchmark. Benchmarking does not leave much room for risk mitigation or variety.
There are options beyond traditional asset allocation. Consult your advisor to see if factor-based investing might be right for a portion of your portfolio.
(Research provided by Brett Lapierre, CFA, KFS Investment Analyst.)
Patricia Kummer has been an independent Certified Financial Planner for 30 years and is president of Kummer Financial Strategies Inc., a Registered Investment Advisor in Highlands Ranch. Kummer Financial is a six-year 5280 Top Advisor. Please visit www.kummerfinancial.com for more information. Any material discussed is meant for informational purposes only and not a substitute for individual advice.