How investors in factor-based indexes take bigger risks

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Andrew Hallam is the index investor for Strategy Lab. Globe Unlimited subscribers can view his model portfolio here and read more in the series online here.

Confucius said, "Life is really simple. But we insist on making it complicated." This could be a great lesson for investors. Low-cost index funds beat most actively managed funds. The actively managed funds that win during one time period rarely win the next. That's why it makes more sense to build a portfolio with simple low-cost index funds.

Many have given up on actively managed funds. But hope springs eternal. Many who want to beat the market have found a different ride. They're called factor-based funds.

A factor-based index is made up of specific types of stocks. For example, a small-cap index contains only small stocks. A value-stock index contains only cheap stocks. A momentum-stock index contains stocks that are rising fast in price. Larry Swedroe, author of The Complete Guide To Factor-Based Investing says rebalancing a portfolio of factor-based funds might reduce volatility and improve returns.

First Asset offers factor-based ETFs. As a firm, they agree with Mr. Swedroe. But factor-based investors fall on sharp swords. Imagine an investor buying the First Asset Morningstar U.S. Momentum Index (YXM.B) three years ago. It's supposed to beat the market. But it didn't. In the three-year period ended Jan. 31, 2017, it averaged 10.3 per cent a year. Vanguard's plain vanilla U.S. Stock Market Index ETF (VUN) trounced it. It averaged a three-year return of 15.7 per cent.

The investor is disappointed. She wants to beat the market, so she sells the Momentum index. She then puts the proceeds in First Asset Morningstar's U.S. Value Index (XXM.B) because it earned a three-year average return of 15.9 per cent. The good folks at First Asset know that investors shouldn't do that. They recommend sticking to a diversified portfolio of different factors. They say investors should rebalance.

But most investors who want to beat the market refuse to do that. They chase winning funds instead. Sadly, funds that win during one time period often lose the next.

As I've explained in a previous column, most investors in broad-based index funds behave really well. For example, measured in U.S. dollars, Vanguard's Total Stock Market Index (VTSMX) averaged 7.1 per cent during the 10 years that ended Jan. 31, 2017. Its investors did even better. According to Morningstar, they averaged 8.1 per cent a year. More of them accepted that they couldn't beat the market. Many added money into the same index every month. By dollar-cost averaging, they paid a lower than average price.

Fewer factor-based investors did the same thing. Here are some examples.

Measured in U.S. dollars, Vanguard's U.S. Value Index (VIVAX) earned a compound annual return of 5.8 per cent during the 10-year period that ended Jan. 31, 2017. But according to Morningstar, the typical investor in this fund averaged just 1.8 per cent. When the fund was doing well, investors added more money. After the fund had dropped, investors jumped to higher ground. That's how they paid a higher-than-average price and underperformed their index.

Investors in growth stock indexes did much the same thing. Vanguard's Growth Stock Index (VIGRX) averaged 8.1 per cent measured in U.S. dollars. Its investors averaged just 5.3 per cent.

Investors in Vanguard's Small Cap Value Index (VISVX) were just as foolish. The fund averaged 7.5 per cent a year to Jan. 31, 2017. But its typical investor only averaged 4.2 per cent.

Investors in Vanguard's Small Cap Growth Index (VISGX) behaved a bit better. The fund averaged a 10-year annual return of 8.1 per cent. Its investors averaged 7.5 per cent.

Those who wish to beat the market often jump around. They chase past winners. Build a diversified portfolio of low-cost index funds. Rebalance once a year and keep adding money. Remember what Confucius said. It's better to keep things simple.