By Peter Dougherty of Bissan Wealth Management

I WROTE about ‘factor investing’ on these pages one year ago.

It’s an investment strategy that became mainstream in the US during the late 1990s and has been gaining worldwide popularity ever since.

Factor investing is being widely embraced in investing circles, but it is not widely understood outside those circles. That’s probably because for many of us, strategies for investing are not particularly interesting topics.

So, what if instead of starting off by discussing investments, I begin by talking about pirates? That’s right, the men and women who years ago sailed the world flying under a ‘skull-and-crossbones’ flag. Would that make the topic more interesting?

READ MORE: Get advice!: There are plenty of reasons to hire a financial advisor in Spain, writes Peter Dougherty

If pirates were alive today, they might realise that buried gold is not a diversified investment portfolio.

I suppose that an ‘X marks the spot’ treasure map should be considered an asset, but if that’s the only holding a person possesses, that individual has concentrated exposure to one asset class: gold.

How might we convince a swashbuckling pirate to balance their investments?   

We could explain to them that factor investing is the practice of targeting specific, historically documented ‘factors’ of return — such as momentum, quality or value — to systematically outperform broad market benchmarks over time.

Most pirates had little to no formal education, but their practical knowledge was often considerable.

As experienced sailors they often understood navigation and rigging, weather, and ship maintenance at an advanced level.

That’s why it might be better to tell them in navigation terms. Just as pirates used different sails because they couldn’t control which way the wind blows, investment firms such as Bissan Wealth Management utilise factor investing to prevent a portfolio from needing to depend on one particular breeze:

• Square sails catch the wind from directly behind the ship and work well when conditions are already moving our way. ‘Momentum’ investing utilises the same idea: riding stocks that are already moving upward.
• A staysail may not provide the spectacular burst of a spinnaker, but it helps the ship remain balanced and make steady progress across changing conditions. ‘Quality’ investing keeps the portfolio balanced when stronger but less reliable winds begin to shift.
• The triangular sail lets ships make progress against the prevailing wind by sailing at an angle. It’s called tacking. ‘Value’ investing works in the same contrarian way: buying stocks that are out of favor and unloved, moving against the crowd’s prevailing sentiment.

Pirates knew which seasons brought storms and which brought calm, and planned voyages accordingly. Factor investors understand that certain factors have cycles of underperformance that can last years, and don’t abandon ship during the rough stretches.

The pirates who regularly scraped their ship’s hulls were faster and more maneuverable than rivals.

‘Rebalancing’ a factor investing portfolio is much like ‘barnacle cleaning’ a pirate ship and does two related things at once:

1) restores target weights— some assets grow faster than others, so actual allocations can drift away from intended targets over time, and

2) refreshes the factors themselves— unlike a market-cap index that requires minimal maintenance, factor investment portfolios should be frequently re-examined as to whether the stocks held still qualify as factor stocks.

A value stock that becomes expensive over time is no longer a value stock, it has ‘migrated’ out of the factor.

So, rebalancing means not just fixing the weights but reconstituting the underlying holdings.

Investment firms utilising factor investing ask themselves two questions: which stocks in our portfolio still have the factor characteristics we want, and which new stocks should we add that now qualify?

A good pirate captain asks the same of his crew: who’s still earning their place on the ship, and who should we be recruiting from the next port?

Peter Dougherty is a Financial Planner at BISSAN Wealth Management in Spain. He holds an MBA in finance from Columbia University in New York and an MS in Spanish taxation (Máster en Fiscalidad y Tributación) from Nebrija University in Spain. He is certified as a European Financial Planner (EFP) in Spain and as a Certified Financial Planner® and a Chartered Retirement Planning Counselor® in the United States.

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