Hard to Factor

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. 

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. 

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.

1. The abundance of quantitative easing in the financial system, exacerbated by COVID-19.
2. 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.

When we compare MSCI World Value Index sector weights to that of the MSCI World Index, the Value index has large underweights to all these sectors and currently does not have any exposure to the FAANGs. 

The FAANGs in particular reflect “expensive” companies which have meaningfully outperformed Value stocks – companies where the stock price is lower than the suggested intrinsic value.

Some Positive Signs for Value

Despite this, over the last two years there have also been signs of a potential reversal in Value’s fortunes. The fourth quarter of 2019 was such a period where Quality and Value both outperformed the broad market. At the time there was a lot of talk about the recovery in Value but that was short lived as COVID-19 took hold through the start of 2020. COVID-19 which halted the recovery in Value may also provide the platform for its resurgence. That’s because Value tends to do well when we are experiencing improving economic growth.

While the world looks to manage through a COVID-19 induced recession, the post recessionary environment should see a strong rebound in economic growth. This could also see a change in dynamics in terms of factor performance, including the performance of Value.

Factor Diversification

However the lesson we can take away from this is one well known in the investing world:

“Don’t put all your eggs in one basket.”

When comparing with the MSCI World Index, year to date we can see that Value has underperformed, Minimum Volatility is broadly in line and Quality has been outperforming through the recovery. 

Going forward we could see rapid changes in factor performance, potentially in line with a post COVID-19 recovery phase. But with ongoing uncertainty created by COVID-19, timing factors will be incredibly difficult, rather a multi-factor approach may serve investors well. As can be seen from this year, exposure to only Value would have resulted in significant underperformance relative to the MSCI World Index. However a multi-factor approach that also included Quality alongside Value would have fared much better. 

Factors for the long haul

Factor investing shouldn’t be viewed through a short-term lens. And while factor investors, in particular Value investors - may feel penalised, going forward they could be realising factor premiums rather than the penalties. Time frames and horizons are always a key element of investing and this holds for factor investing. Factor investing is a long-haul journey that seeks to capture a return premium. Given factor performance is cyclical, you may be better maintaining a diversified factor exposure and looking to harvest those premiums over the long term.