Does factor investing still work?

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Ethan Wu (0:36)

Thank Pushkin.

We've discussed on the show the dual between active and passive investing. Active where you're taking a view on the market, passive where you're just accepting what the market delivers to you. But what if I told you that you could have the best parts of passive and the best parts of active all in one investing strategy? Too good to be true? Today on the show, factor investing.

This is Unhedged, the Markets and Finance show from the Financial Times and Pushkin. I am reporter Ethan Wu here in the New York studio joined from London by markets columnist Katie Martin, the scourge of the factor investing world. I think it's fair to say.

Katie Martin (1:20)

I don't know about that, Ethan Wu. It's a bit much.

Ethan Wu (1:24)

We'll see. Listeners, you can decide if Katie is really the scourge of factor investing because Katie's just written a quite skeptical column about the investing strategy, which we'll get into in a minute.

Around the very same time that Rob Armstrong and I traveled to Greenwich, Connecticut, we took the train up from New York City from Grand Central Station, and went to visit the offices of Cliff Asness of AQR, one of the biggest, most important quantitative hedge funds and factor investing hedge funds. To have a kind of wide ranging discussion about factor investing value, all kinds of stuff, you can read about it in the Unhedged newsletter. But we thought it would be a good time to talk about, what's the case for factor investing?

And why Katie doesn't buy it? But before we get there, Katie, we need to start with what the hell is factor investing? And I'm throwing to you first, because I do not know how to explain it.

Katie Martin (2:11)

I think the simplest way to think about it is that, you can invest just based on what you call beta.

So when I say beta here, this is a reference to the Greek letters, right? So alpha is the amount of special return that you can make as an investor, layered on the top of your beta, which is, or beta, if you want to sound even cleverer, which is the kind of basic return that comes out of the market based on a big index like the S&P 500 This is something that's in between that. It picks out individual stocks and bunches them together in different ways. And so you have something that people have called smart beta, smart beta, you know, you can choose which one you prefer. That is a kind of a cleverer way of tracking a large number of stocks in a kind of mathematical way. But that is not quite stock picking where you are saying, I think this retailer, this oil company and this tech company are going to beat the rest of its peers.

Ethan Wu (3:08)

Yes, thank you for translating not just from Greek, but also to American from British.

Katie Martin (3:13)

So for example, you can say, I just want to buy momentum stocks, stocks that have got a provable track record recently of moving higher. So I only want, I just want to chase the winners because I think that those winning patterns can sustain themselves.

Or you can say, I think small caps, you know, small companies, small capitalisation companies have superior qualities to large companies. So I want to buy small caps.

Or you can say, I want to buy stocks that are attached to large dividend payments. I want to buy income stocks. Or you can do what is probably the most popular of them all and say, I want to own value stocks. So not the whiz bang kind of fast growing companies that currently dominate the US market in particular, but kind of beaten up unloved value stocks that are kind of cheap relative to, or that you can argue are cheap relative to the quality of the business.

Ethan Wu (4:13)

No, that's exactly right. There's all these different nuances. But the key thing is that you're trying to get at these fundamental attributes.

And I think it's all based on the idea that there's some kind of behavioral quirks in markets that are built in, right? Take momentum, for example, Katie, that you mentioned. So stocks that go up tend to keep going up in general, at least for some amount of time.