In stark contrast to the U.S., where ETFs account for over 30% of assets and factor funds claim a substantial 21% of that ETF market, the Canadian investment landscape lags significantly behind. Here, a mere 23% of assets are held in ETFs, with only 3% allocated to factor funds. This disparity highlights a tremendous opportunity for growth in factor investing within Canada, and Eddy Wealth is at the forefront of this movement.

What Is Factor Investing?

Factor investing, a strategy that has gained significant traction in recent years, is rooted in decades of academic research and empirical evidence. It is a systematic investment approach that seeks to capture excess returns by targeting specific stock characteristics, or “factors,” historically associated with outperformance.

The concept of factor investing can be traced back to the 1970s, with the development of the Arbitrage Pricing Theory (APT) by Stephen Ross. APT challenged the prevailing Capital Asset Pricing Model (CAPM) by suggesting that multiple factors, not just market risk, drive asset returns. This laid the groundwork for identifying and exploiting various factors that could explain and predict stock performance.

Since then, extensive research has been conducted to identify and analyze various factors. Some of the most well-known factors include:

• Value: Stocks trading at lower prices relative to their fundamental value, such as book value or earnings.
• Momentum: Stocks with recent strong price performance, which tends to persist for some time.
• Quality: Companies with strong financial health, stable earnings, and effective management.
• Low Volatility: Stocks with lower price fluctuations compared to the overall market.

By systematically tilting their portfolios towards these factors, investors aim to capture the premiums associated with them and achieve superior risk-adjusted returns compared to traditional market-cap-weighted indexes. The growing popularity of factor investing can be attributed to its strong empirical evidence, transparency, and the availability of various factor-based investment products, such as exchange-traded funds (ETFs).

Factor investing represents a significant shift in investment philosophy, moving away from traditional stock-picking based on subjective analysis towards a more systematic and evidence-based approach. It offers a compelling alternative for investors seeking to enhance their portfolio returns and diversify their sources of risk.

Factor Investing with Eddy Wealth: Exploring a Potential Path to Lower Fees and Enhanced Performance

Canadian investors have long favoured actively managed mutual funds, with a significant portion of their investments currently allocated to this category. However, this preference can come with trade-offs, including potentially higher fees and the possibility of underperformance. Research suggests that many active funds may struggle to consistently beat their benchmarks, which could leave investors with returns that fall short of expectations.

One factor that might contribute to the potential underperformance of active funds is the fees they charge. Consider the RBC Select Balanced Portfolio, which was recently profiled by Tim Shufelt from the Globe and Mail, “Let’s say you sock away $5,000 each year in a portfolio fund like RBC Select Balanced Portfolio, which is the largest mutual fund in the country, with more than $50-billion in investor money. Assume it gains an average of 6 percent a year. The fund has an MER of 1.94 percent, meaning that after 40 years of saving, you would have paid about $320,000 in fees. Nearly 40 percent of your invested wealth would be swallowed up by fees.[1]”

Eddy Wealth: Your Partner in Exploring Factor Investing

At Eddy Wealth, we believe in exploring investment approaches with solid academic backgrounds. We specialize in factor investing, a passive, typically lower-fee strategy grounded in academic research. This strategy systematically targets specific market characteristics, such as value, momentum, or low-beta stocks.

Insights from Research:

• A relatively small percentage of active funds may generate positive alpha (excess return) over the long term.
• Factor funds have historically shown the potential to outperform their actively managed counterparts, exhibiting higher success rates in achieving positive alpha.[2]

 Understanding Alpha

Alpha represents the excess return of an investment compared to its benchmark index. It serves as a gauge of the value a fund manager or strategy may add beyond simply tracking the market.

• Positive Alpha: Suggests the investment may have outperformed its benchmark.
• Negative Alpha: Suggests the investment may have underperformed its benchmark.
• Zero Alpha: Implies the investment may have performed in line with its benchmark.

Illustrative Example: A Hypothetical Scenario

Let’s explore a hypothetical scenario involving a $1 million investment in two strategies: your current active mutual fund and a multi-factor fund.

Assumptions:

• Current Active Funds: Let’s assume your current actively managed funds have an alpha of 0. We’ll also assume a standard deviation (volatility) of 10% for these funds.
• Multi-Factor Fund: Based on research, let’s hypothesize the multi-factor fund to have an alpha 1.36 standard deviations higher than your current funds.

Hypothetical Calculation:

• Alpha Difference: 1.36 standard deviations * 10% standard deviation = 13.6% alpha difference
• Potential Additional Return from Multi-Factor Fund (Hypothetical): $1,000,000 investment * 13.6% alpha = $136,000 potential additional return per year

Potential Long-Term Impact

This hypothetical additional return could significantly impact your long-term financial goals over time. However, it’s crucial to remember that this is merely an illustration, and actual results may vary depending on market conditions and specific fund choices.

Key Considerations

• Hypothetical Illustration: This example is for illustrative purposes only. Actual results can differ based on market dynamics and specific investments.
• Long-Term Focus: The potential benefits of factor investing typically unfold over extended periods. Maintaining a disciplined, long-term approach is crucial.
• Risk and Return: While factor funds offer the potential for enhanced returns, they also carry inherent risks. Ensuring your portfolio aligns with your risk tolerance is paramount.

Conclusion

The hypothetical impact of a higher alpha underscores the potential advantages of exploring factor funds as part of a diversified portfolio, particularly for those with long-term financial goals.

Remember, it’s vital to consult a financial advisor to discuss your unique circumstances and develop a personalized investment plan tailored to your risk tolerance and objectives.

Explore Your Options

Consider whether factor-based strategies might be a suitable addition to your investment journey. By exploring these strategies, you may have the potential to:

• Enhance returns
• Manage risk
• Lower costs
• Pursue your financial goals with greater confidence

Take the Next Step

Partner with Eddy Wealth to delve deeper into factor investing and its potential role in your investment strategy. Our expertise can empower you to make informed decisions and build a brighter financial future. Explore the evidence, consider the possibilities – take the next step towards unlocking your investment potential.

Disclaimer:

This information is for educational purposes only and should not be considered investment advice. Eddy Wealth is a registered portfolio manager, and all investments involve risk. Past performance is not indicative of future results. Please consult with a financial advisor before making any investment decisions.

[1] Despite high fees, Canadians remain perplexingly loyal to mutual funds. Here’s why. Tim Shufelt, Investment Reporter Globe and Mail. Published April 13, 2024.

[2] Factor Investing from Concept to Implementation The Journal of Portfolio Management, Quantitative Special Issue 2019. Eduard van Gederen, Joop Huij, Georgi Kyosev.