Many multi-factor smart beta funds have been critiqued over the last year.
In the last decade, Value has been a commonly targeted factor in these strategies and has severely lagged the broader market.
So why has Value underperformed and why is it important to maintain a multi-factor approach?
Factor investing is an investment approach that involves targeting specific drivers of return across asset classes. Investing in factors can help improve portfolio outcomes, reduce volatility and enhance overall portfolio diversification. When we talk about factors in a smart beta context, we are generally talking about style factors as opposed to macro factors. The typical style factors we find quoted in academic literature are:
Value - Value stocks are companies with attractive fundamental ratios such as Price/Book or Price/Earnings. These cheaper stocks are perceived as distressed or susceptible to macro shocks.
Minimum Volatility - Lower volatility stocks tend to generate a higher risk-adjusted return than high volatility stocks.
Quality - Quality companies are those with high and stable profitability, low earnings growth and low leverage. Healthy companies tend to outperform less healthy companies.
Size - Stocks of small companies tend to earn greater returns than stocks of larger companies. Small cap stocks are perceived to have less stability, liquidity and cash flows.
Momentum - Stocks with good recent performance tend to continue earning greater returns in the near term compared to stocks with weak recent performance. Succumbing to bandwagon effect, anchoring bias and preference for past winners.
The appeal of factor investing is that factors have been shown to outperform the broad market over the long term.
Source: Bloomberg Finance L.P., MSCI, Indexes are MSCI Factor indices in AUD.
Time horizon is an important consideration for factor investing, as longer time frames increase investors ability to harvest factor premiums when compared to shorter periods of time, where factors may experience periods of underperformance.
Getting to Grips with Values Underperformance
One factor that has come under more scrutiny than others has been Value. In particular, over the last two years, the underperformance of Value has garnered more attention. Over this period Value has significantly underperformed the broader index.
Source: Bloomberg Finance L.P., MSCI, MSCI Value in AUD.
Year to date, the MSCI Value Index has underperformed the MSCI World Index by almost 15%. However the underperformance of Value can be attributed to two key themes.
The abundance of quantitative easing in the financial system, exacerbated by COVID-19.
The rise in prominence of technology related stocks. These include not just pure technology stocks such as IBM or Apple but also companies that leverage technology in their business model. An example would be Amazon which is a technology based consumer discretionary company.
A Broad Collapse but Narrow Recovery
As we think about 2020, the first quarter sell off for the stock market was broad but the recovery has been relatively narrow, and is driven by the information technology sector, the consumer discretionary sector and the consumer services sectors. These three sectors being categories of the FAANGs (Facebook, Amazon, Apple, Netflix and Google) – which make up over 10% of the MSCI World Index by themselves. These sectors and stocks have driven the performance of the Growth and Quality factors and resulted in the relative underperformance of Value.