When we consider which equity factor has performed the best this year, momentum stands out from all the rest. As defined by MSCI factor-tilted indices, momentum has gained 32% through the end of November in the MSCI World Index, in unhedged US dollar terms. Most other factor indices are up around 20%, in line with the global benchmark return year to date.1
In a classic pattern we often find when nothing else is sending a strong signal, momentum can become the one factor driving market performance. And we certainly saw that with the glamour technology stocks making the headlines, prompting us to call 2017 the year of momentum. But in 2018, we expect the market to broaden out beyond momentum, with the potential for other factors to take the lead. In our view, investors who can navigate this environment may find opportunities to add value through judicious exposures to factor and stock-specific risk.
Factor Valuations — No Cause for Alarm
To support that expectation, we can look at where global factor valuations stand today. As an indicator, we use book-to-price (B/P) spreads, ranking the MSCI World Index across each of four factors — value, quality, size2 and low volatility — and comparing the median B/P in the first quintile with the median B/P in the fifth quintile. Figure 1 shows how these factor valuation spreads have moved through time, relative to the average spread over a 10-year look-back window.
Across the four factors, we see a lot of variability in these spreads. But at this point, all are within the bands marking one standard deviation above and below their averages — in line with 68% of the observations. Value is right on the cusp of expensive, while quality is at the other end of the spectrum, the most attractively priced of the factors. Size, which tends to mimic value to some extent, is also on the expensive side, and low volatility is the closest to its average. So value and size are the factors to monitor, yet as long as they remain within their one standard deviation ranges, we see no cause for alarm.
Factor Return Expectations — Positive but Nothing Extreme
Comparing B/P spreads with subsequent three-year returns, we can observe that valuation does matter to factor performance, if only a little in magnitude (see Figure 2). Yet there is a directional component to the relationship between how cheap a factor is now and how it performs over the next three years. The teal dot represents where each factor stood as of September 30, 2017 in terms of its B/P spread, which we have fitted to the line to suggest what its three-year return would be if the historical relationship holds.
According to this analysis, B/P spreads have been a somewhat more powerful predictor of subsequent three-year returns within low volatility equities — as evidenced by a slightly steeper slope and a marginally tighter relationship. Given the current B/P spread alone, we would expect low volatility to offer higher returns over the next three years. Quality may also hold more promise, consistent with the connection we observe between this factor and low volatility — that is, stocks exhibiting higher return on assets, lower earnings variability and lower debt-to-equity tend to overlap with those experiencing lower volatility. And there is a strong historical relationship between value and size, both of which are price-based measures. Their more expensive valuation spreads at present suggest slightly lower expected three-year returns for these two factors.
The bottom line is that given where spreads are now, based on historical relationships, all four factors could offer positive performance. While low volatility may look the best, we would avoid trying to differentiate too much between the factors, as there has been wide dispersion in these relationships. Again, we expect nothing extreme.
Factor Positioning — Tilted Toward Sentiment, Away from Risk
Our active quantitative equity team has developed proprietary definitions of value, quality, risk and sentiment — a variation on momentum. Across the four developed market regions of Asia Pacific, Europe, Japan and North America, the portfolios are tilted toward sentiment, which is no surprise after the strong performance of momentum in 2017. Relative to the historical positioning, quality and value have been roughly in line, while these regional portfolios have tilted away from higher risk.
From a valuation perspective, sentiment, value and risk have become more expensive while quality is getting cheaper in Japan, but not enough to alter our positioning heading into 2018. A factor’s most recent performance — its own momentum — can influence our weighting. Where we are from a macro standpoint also comes into play.
On a monthly basis, we use a proprietary style cycle measure to assess which part of the cycle we believe we are in and adjust our factor allocation accordingly. As of mid-November 2017 we had a slowdown signal in Europe and Asia ex Japan, so we would favor sentiment and quality over risk and value. In the boom environments of Japan and North America, we favor sentiment and risk while we tend to be neutral on value.
Factor Opportunities — Focus on Value with Earnings Power
Through November, with the MSCI World Value Index trailing MSCI World by about five percentage points, 2017 has been a difficult year for value. We have pointed out the change in the complexion of value over time.3 While value investing was traditionally associated with more defensive sectors, we think value is now driven by more cyclical sectors. With that change in composition comes increasing risk of economic sensitivity and the potential for earnings drawdowns over the cycle.
The implication for fundamental value managers is to focus not only on a company’s price-to-book (P/B) rating but also the rating of its capital and the earnings power associated with that equity capital — in other words, whether its balance sheet is capable of generating sustainable and sufficient earnings to take us through to the next cycle. We believe that focus may help us avoid the value trap, which is the occupational hazard of the value manager. For value investors, this means looking for managers who can embrace the new opportunity set of value, while avoiding managers who have continued to own the more defensive sectors and watched their style drift away as those valuations have risen.
Overall, however, we find that factor valuations are well behaved at the end of 2017, with none sending extreme signals that would cause us to significantly alter the factor positioning in our portfolios for the beginning of 2018. To us, such an environment should be conducive for active managers who can add incremental return by taking selective exposures to idiosyncratic risk.
1Past performance is not a guarantee of future results. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns do not reflect capital gains and losses, income, and the reinvestment of dividends. You cannot invest directly in an index. Performance is calculated in USD.
2Here we mean small size within what is technically a large cap index — so the smaller stocks versus the larger stocks in the MSCI World universe, which is not the same as looking at a small cap index relative a large cap index.
3SSGA Blog, “Where’s the Value?” by William Killeen and Oliver McClure, August 9, 2017. Past performance is not a guarantee of future results. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns do not reflect capital gains and losses, income, and the reinvestment of dividends. You cannot invest directly in an index. Performance is calculated in USD.
Book-to-Price (B/P) Ratio: A valuation metric used a proxy for how expensive a security is. The B/P ratio is the inverse of the price-to-book (P/B) ratio.
Low Volatility: The volatility factor is a common driver of equity returns that is based on the observation that lower volatility stocks tend to generate a higher risk-adjusted return than high volatility stocks.
MSCI World Index: A broad global equity benchmark that represents large and mid-cap equity performance across 23 developed markets countries. It covers approximately 85% of the free float-adjusted market capitalization in each country and does not offer exposure to emerging markets.
MSCI World Value Index: An index designed to track captures large and mid-cap securities exhibiting overall value style characteristics across 23 developed markets countries. The value investment style characteristics for index construction are defined using three variables: book value to price, 12-month forward earnings to price and dividend yield.
Quality: The quality factor is a common driver of equity returns that is based on the observation that healthy companies tend to outperform less healthy companies.
Size: The size factor is a common driver of equity returns that is based on the observation that stocks of small companies tend to earn greater returns than stocks of larger companies.
Standard Deviation: A measure of dispersion around an average.
Value: The value factor is a common driver of equity returns that is based on the observation that inexpensive stocks tend to outperform more expensive stocks.
The views expressed in this material are the views of Geoff Kelley, William Killeen, and Gaurav Mallik through the period ended 12/5/2017 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
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