By Jack Forehand (@practicalquant)
Factor Investing poses some interesting challenges for wealth managers. On one hand, the evidence is very strong that investing using factors produces superior to returns to market cap weighted indexes over the long-term. On the other, factor strategies introduce another set of behavioral problems for clients because the extended periods of underperformance that are common in factor investing can lead to bad decision making and underperformance relative to index funds if investors aren’t able to stay the course during them.
For this week’s interview, we wanted to talk to someone in the wealth management space to see how they view the trade offs that come with utilizing factor-based portfolios as part of their overall investment strategies. Michael Batnick is the Director of Research at Ritholtz Wealth Management and one of the best financial bloggers out there. If you don’t read his blog, The Irrelevant Investor, I highly recommend that you start to. He is also the author of Big Mistakes: The Best Investors and Their Worst Investments and the co-host of the Animal Spirits podcast.
Ritholtz Wealth is one of the fastest growing wealth managers in the country. As a member of their investment committee, Michael is in a unique position to offer some insights on the pros and cons of using factor-based strategies in client portfolios. In this interview, I get his take on that topic, and several other issues currently facing investors.
Jack: Thank you for taking the time to talk to us.
From the outside looking in, I would think that factor investing presents an interesting dichotomy for a wealth manager. On one hand, the long-term returns of the major factors like value and momentum would seem to support using them in client portfolios, but on the other, the extended periods of underperformance that can occur with factors present a behavioral challenge. If clients can stick with them during the bad periods, then factors should offer the opportunity to enhance returns, but if they can’t then clients are likely better off in index funds. As someone who builds the models used for client portfolios, how do you look at this trade off and the pros and cons of using factors?
Michael:
It’s often been said that the best portfolio is the one you can stick with and I subscribe to this idea. The advisor might feel confident that a set of factors will provide better long-term returns, but if the client can’t stick with it during the inevitable periods of underperformance, then long-term is irrelevant. The long-term is only a series of short-terms and you have to understand that client’s don’t know as much as you and might not be able to stick with a factor if it has underperformed for a few years. Even though a few years might be meaningless to academics, its very meaningful in the real world.
Certain factors have provided better returns than the market historically, but there are no guarantees that the ones that worked in the past are the same ones that will work in the future. I think you have to balance the evidence of the market with the evidence of human behavior.
Jack: What is going on with value investing right now offers a good real-world example of the extended bad periods that can occur with factors. It also has sparked an interesting debate about the future of value. The long-term evidence strongly supports value investing, and previous extended periods of underperformance were all followed by a reversal. But some argue that quantitative investing and big data have made value much harder than it once was. And technology has been a headwind for value both because it underweights stocks in the industry and because firms like Amazon are taking share from traditional value companies. What are your thoughts on the future of value investing? Do you still think it will offer the outperformance in the future that it has in the past?
Michael:
I go back and forth on this a lot, so I guess that tells you that I don’t feel too strongly either way. If I had to pick a side however, I would say that value investing is a way to arbitrage our behavioral biases, and the only reason why it works is because there are long periods like today when you question if it ever is going to work again. I think it’s fair to suggest that the days of net nets are long gone, and maybe we have to be more realistic with our expectations going forward.
Jack: I referenced behavior above as it applies to factor investing, but in reality, it is probably the biggest issue standing between most investors and their long-term investing goals regardless of how they invest. I am a regular reader of your blog and the blogs of your colleagues at Ritholtz and this issue seems to be a primary focus for all of you. Since you have been at Ritholtz from the beginning, I am wondering what you have learned about how to best manage client behavior and what tools or approaches tend to produce the best results?
Michael:
We all understand that the index is very difficult to beat over long periods of time. We also know that buying and holding the index over long periods of time is no walk in the park due to the tendency of markets to lose half their value from time to time. And when it does, we don’t think it’s fair or reasonable to tell our clients, “don’t worry the markets always come back.”
In the heat of the moment, we need to have a rules based method to de-risk, which allows us to avoid the all-in all-out decisions that can be catastrophic to building and preserving your wealth.
We’re just as susceptible to bad behavior as anyone else, which is why the tactical model does not rely on any intuition.
We believe in index funds, but we also believe that feelings trump everything else, so we try to blend the best of strategic asset allocation with a tactical component so that they can stick with what we’ve recommended when the going gets tough.
