(I hope you have your big boy pants on today because I am about to unleash another beat down on factor investing. I apologize in advance to all my colleagues in finance who love factor investing so much.)

Factor investing is all the rage these days. If you don’t know what it is, stop being such a loser and get with the times.¹ Factor investing involves allocating your portfolio to certain “factors” that have been shown to generate excess returns. The most popular factors are value, size and momentum, but there are hundreds to choose from. In the last 10 years there has been an explosion in new funds selling you excess returns in exchange for higher fees. And while it’s easy to come up with an academic theory about generating alpha the reality is that it’s very hard to create an actual fund that captures that alpha. I got to thinking about this while reading this fantastic post by Wes Gray showing that a high number of factor funds are closet index funds. The SPIVA Scorecards also strongly support this view:

Of course, the defenders of factor investing will say that most of these funds don’t implement the factors correctly. But that’s what alpha salesman always say – “those other guys just don’t do it right so pay me the high fees and give me a chance!” But the evidence clearly shows that those selling equity alpha cannot consistently generate the high returns they promise.

This makes absolute sense. A stock is just a claim on a corporation’s cash flows. Corporations will appear different at different stages in their lives, but it’s very difficult to build a diversified portfolio of stocks and know whether you own the corporations that are actually “growth” or “value” or whatever. This is why market cap weighted asset allocation works so well – you take the guesswork out of the equation. You don’t need to pick which factors are the best or the worst because you own them all. That’s the beauty of diversification. You don’t need to own the best stuff. You just need to own enough of the best stuff to generate good results.  All the while you’re saving bigly on fees which is where the real excess return comes from relative to high fee funds.