A great way to filter out the rubbish stocks

If you're investing in equities, style matters. By style, I mean a fund manager's investment ideology of which "value investing", la Warren Buffett, is probably the most famous. Most fund marketers would rather talk up the manager's unique stock-picking skills, or talk about the sector or theme behind their fund. But the manager's style bias matters, because different styles go in and out of fashion, and investing in the wrong one at the wrong time can have a big impact on your returns.

Big institutional investors have been investing based on specific styles (or "factors") for years. They prefer to take humans out of the equation, replacing them with a systematic form of stock screening. Over the last five years, the top-performing style has been "momentum investing" where you consistently buy the stocks that are rising fastest relative to the wider market. This approach delivered 11.2% a year, closely followed by "quality investing" (where you buy a "quality" business and rely on its consistent earnings growth to lift the share price), on 10.8% per year. By contrast, the ACWI index, which measures conventional global indices, has delivered 9.6%.

So if you choose the right "factor", you can beat the broader market. And in recent years, marketing types have jumped on the opportunity to build "smart-beta" exchange-traded funds (ETFs) that track different "flavours" of investing. However, as we've already alluded to, the problem is that different investing styles go in and out fashion, frequently for years at a time.

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For example, while momentum investing did well in the last few years, if you'd bought into this factor in the late-1990s, you'd still be sitting on big losses. So single-factor ETFs might be a neat idea if you're very knowledgeable about investing, but many are just too clever for mainstream investors.

So what happens if we diversify instead if we combine all of the major factors into one multi-factor index? By combining styles, we should be able to make sure that we outperform the wider market in virtually all circumstances. For instance, according to a recent paper by index provider S&P Dow Jones, a multi-factor version of the S&P 500 would have delivered superior returns relative to both the individual factors and to the underlying index. How can that be?

By combining all of these different factors into one index, aren't you just ending up with what we started with namely the broad market? In fact, no. You see, within a broad index such as the FTSE 100, overall performance is constantly let down by a long tail of what can only be described as "rubbish" stocks stocks with very few redeeming virtues, and absolutely no factors in evidence. They're not cheap, they don't demonstrate momentum so don't buy them. A multi-factor index filters out all of the rubbish stocks, which is why it should outperform consistently.

That's the theory how about the practice? To date, there are only a few multi-factor ETFs out there, and after a year, performance has been lacklustre multi-factor ETFs from Goldman Sachs and iShares have struggled to keep up with their plain-vanilla rivals. However, I think it's worth being patient. This is just the start of an interesting experiment in multi-factor investing. In theory, the absence of poor-quality stocks from multi-factor ETFs should help them to outperform in any future downturn so watch this space.

In the news this week

US passive fund giant Vanguard is to sell its funds direct to UK investors via a new online investment platform, VanguardInvestor.co.uk. Vanguard is already popular for its extremely cheap tracker funds (its FTSE 100 tracker charges a tiny 0.06% a year), and the new platform offers a very cheap way to buy them.

Vanguard's platform will charge an annual fee of 0.15%, capped at £375 (for a £250,000 pot). That compares with 0.45% for holding the same funds with Hargreaves Lansdown, one of the UK's top online brokers. It's perhaps no surprise that Hargreaves' share price fell by 8% on the news of its new rival.

Before you get too excited, it's worth noting a couple of points. Firstly, the Vanguard platform only offers Vanguard's own products. So if you want to buy investment trusts, individual stocks, or anything from a rival financial group, you'll need to go elsewhere. Also, while Vanguard currently offers an individual savings account (Isa), the self-invested personal pension (Sipp) option isn't there yet (although it should be coming within the next year). Finally, if you have a large portfolio, a fixed-fee broker may still be a cheaper option for you.

That said, this is great news for investors. As credit-rating agency Moody's notes, the move by a rival of this scale has the real potential to "disrupt the UK retail market" and not just direct rivals such as Hargreaves. Active fund managers will also "face fee and margin pressure" as Vanguard's move sees more investors opt for passive funds.

Activist watch

Shares in AthenaHealth jumped by 22% last week on the news that activist investor Elliott Management had amassed a 9.2% stake in the online medical-billing provider, says Zachary Tracer on Bloomberg. Prior to the news, the share price had fallen by 19% over the past year, but Elliott believes the company is "substantially undervalued".

The company's "management quirks and recent poor performance" make it "prime deal bait", says Bloomberg Gadfly, and in a regulatory filing, Elliott said that it may propose "changes to the company's operations, board and dividend policy", as well as a potential sale to realise its value. AthenaHealth "looks forward" to hearing Elliott's views on "its actions to drive growth and create value for all shareholders", according to a spokesperson for the company.