The multi-faceted nature of equity factor investing means it can play a dynamic and highly useful role in portfolios, especially for investors looking for a diversified exposure that can perform in the long run.
Investment performance of quantitative factor-based strategies has been varied recently for a number of reasons.
- For one, the styles that make up multi-factor investing – value, quality, momentum, low-risk and small caps – don’t all have the same performance across time, so a greater allocation to the small cap and value factors did not pay off recently.
- Performance also differs depending on the choice of the factors that go in each style as well as choices such as whether you diversify more or less or whether you neutralise sectors.
- Finally, investors who can take more tracking error can get better performance in good times.
Our experience with sector neutral value investing has been positive. Our models saw good performance from 2000 until mid-2018, with a blip in 2009. However, despite the fact that we choose to control for sectors, value stocks did poorly in 2019/2020. Indeed, irrespective of whether we use the price-to-book ratio as a value factor, all value factors did poorly in late 2019 and in 2020. Only now, in 2021, have value factors started performing well again.
Value stocks face a favourable stretch
It is important to recognise that the value style seeks to benefit from cheap stocks converging to their fundamental values; for expensive stocks, that entails that performance has to be poorer for valuations to converge with those of cheaper stocks. That did not happen in 2019 and 2020, causing value spreads to widen to levels last seen in 2000 tech bubble.
Given the premise of value investing, we are facing a favourable period for value stocks because it’s more likely that we will see value spread compression than further spread expansion. This new trend may have started already with the strong performances of value stocks so far in 2021.
Low-vol stocks – We need a higher market beta
2020 was also the year when the low-volatility premium was not there. A low beta in bullish markets makes it difficult for low-vol stocks to do well. The outperformance of mega caps also did help since owning those would most likely have meant a large underweight in low-vol stocks.
This is also showing signs of changing in 2021. However, as the markets remain positive and strong, low-volatility stocks are still just about delivering market performance.
Sit tight – It is about performance over time
We believe that the performance of value and low risk (volatility), as well as quality and momentum, in well-diversified multi-factor strategies should be assessed over the long run.
Adding in an ESG perspective to such balanced portfolios does not detract from their ability to perform, especially when it comes to quality and low risk, which tend to fit well with a sustainability-based approach. We find it natural that ESG is aligned with the type of factor exposures we have in our quant equity multi-factor approaches.
*This is an edited extract from a roundtable discussion Raul Leote de Carvalho took part in and Daniel Morris moderated, run by European Pensions.
