IN RECENT YEARS, there’s been much buzz about so-called factor investing—favoring groups of stocks that academic research suggests will generate superior returns over the long haul. But those superior returns are by no means guaranteed and, indeed, the various factors have occasionally suffered long periods of underperformance.
Among the most popular factor tilts: overweighting small-company stocks, bargain-priced value shares, stocks displaying upward price momentum and companies with high gross profitability. There are now mutual funds and exchange-traded funds available that seek to exploit all these factors.
For those who don’t mind greater complexity, factor investing is an intriguing way to shoot for somewhat better returns—and it seems more promising than, say, picking individual stocks or betting on star fund managers. Intrigued? You might stash part of your portfolio in a few U.S. and foreign stock index funds that favor, say, value stocks or smaller companies.
How much of a tilt should you give to your portfolio? It all depends on how much tracking error you’re willing to suffer. While total market index funds offer relative predictability—they’ll give you whatever the broad market delivers—factor index funds may generate results that look quite unlike the well-known market averages. If your factor funds badly lagged behind the broad market for five years, would you bail out? If so, you should probably keep factor funds to 10% or less of your stock portfolio—and there’s nothing wrong with skipping them entirely.
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