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Beta Blocks 2: Going full tilt for profits

James Norrington revisits a Smart Beta strategy combining value and momentum factors
November 20, 2015

The exchange-traded product (ETP) industry is going from strength to strength in Europe, gathering a record $61.6bn in the year to date by the end of the third quarter of 2015 (Source: ETFGI.com). The pace of innovation is also speeding up, with several new products targeting smart beta factors that aim to help 'passive' investors outperform the market. ETFs tracking factor indices based on small-cap size, value, low volatility, momentum, income and quality are now available (see Beta Blocks, 12 June 2015). There are also composite strategies emerging and one of these, First Trust Global Portfolios' combination of value and momentum, provides the inspiration for an experimental screening of the FTSE All-Share.

A 2013 study by Asness, Moskowitz and Pedersen (using data from 1972 to 2011) found a negative correlation between value and momentum of -0.53 in the US and -0.52 globally. The work of Fama and French (value) and Jegadeesh and Titman (momentum) has provided evidence that these factors have also outperformed various international benchmarks over time. It follows therefore that value and momentum together ought to provide market outperformance and a degree of diversification. Simulations conducted by First Trust Global Research, using data from between 1990 and 2014, have shown this to be the case for the 1,000 largest US companies. Ranked by First Trust's composite value and momentum screening criteria, the top-ranking quintile of these 1,000 stocks have comfortably delivered the best returns in absolute terms and relative to risk.

Quintile in value/mom rankingRisk - Standard deviation (%)Annualised return (%)
Top quintile17.20%16.50
Second15.5013.60
Third15.3011.70
Fourth15.5011.30
Bottom quintile19.908.70

 

UK value and momentum screen

For a UK screen based on the First Trust methodology, the starting universe we took was FTSE All-Share companies with a market capitalisation of at least £500m. For a value ranking, shares were listed by their average placing when rated according to: lowest price to book ratio; lowest price to cash flow ratio; and highest percentage return on assets. The universe was also tested for five different momentum indicators: three-month, six-month and one-year price changes; one-year revenue growth; and lowest to highest price to sales ratio. The mean value of the rank each stock had for all five criteria was taken as the overall momentum score. To create a composite value and momentum screen, companies were given their highest rank from the two broad value and momentum categories. The final list was in order of the top-ranking company by value, the top by momentum, the second by value, the second by momentum and so on.

In our UK system, the idea is to track a manageable selection of shares; so rather than monitor the whole universe, we will follow just the top 100 companies and split this list into quintiles. All five of the portfolios can be

and the top and bottom quintiles are shown here. Our UK methodology is not back-tested so, with no proof of concept for the exact screening criteria, these companies are certainly not recommendations on the back of the system itself. Further research is required to assess individual investment cases, but looking through past Investors Chronicle analysis, it is reassuring to note that eleven of the companies in the top quintile were placed on a 'buy' the last time our writers covered their results and none were rated as a sell. In the case of the fifth quintile, 12 of the 20 companies were rated buys by the IC companies team, with the rest on a hold.

To be absolutely clear, there are added risks attached to selecting a portfolio in this way, even if the investment case for individual companies is strong. For example, it is notable that shares with the same factor tilts seem to be affected by similar headwinds and tailwinds in terms of the wider economic cycle, which gives cause to think about diversification. In the case of momentum, companies with earnings buoyed by strong consumer demand and house prices have ranked highly. For value, companies that are out of favour due to their exposure to commodities prices are cheap. It remains to be seen whether the negative correlation between value and momentum factors observed in the past will persist and, if so, whether it will be sufficient to mitigate an apparent lack of broader diversification. The bottom quintile portfolio does, on the face of it, appear more diverse than the top quintile, although the selection of both BHP Billiton (BLT) and Rio Tinto (RIO) should raise eyebrows. Diversification rules are an option, but this concentration is down to the factor tilts that we want to fully observe. Of course, it is always possible to blend screening with judgment calls on which stocks in the same industries one would rather hold.

Even though the selections are rules-based, a degree of active management is still required to deal with corporate actions. Of the top quintile shares, Amlin (AML) is the subject of a takeover bid and Betfair (BET) is in the middle of a proposed merger with Paddy Power (PLS), so both companies are excluded. Rather than just selecting the next couple of companies down in the list, we will start the top quintile portfolio with just 17 shares; Royal Dutch Shell's 'A' shares are also left out as the 'B' shares (RDSB), which pay dividends in London, are included too.

Looking at divisions of just the top 100 shares by our criteria, is a concentrated approach compared with the more rigorously tested US methodology of First Trust Global Portfolios, so it could well be that our top quintile of shares is not the best performing in the long term. First Trust's successful back-testing is also based on an equal-weighting and quarterly rebalancing approach that would be prohibitively expensive for a private investor. Going forward, it will be necessary to take a view on rebalancing frequency and price targets that can make our system more easily investable. The approach to profit-taking and selling needs to be cost-effective and along with scrutiny of the portfolios' performances, these issues will be returned to in a review in three months' time.

 

Top quintile

NameSectorValue rankingMomentum rankingLast IC view
Wizz Air Holdings (WIZZ)Travel & Leisure10na
JD Sports Fashion (JD.)General Retailers1041Buy - 16/09/2015
Centamin (CEY)Mining282Hold - 15/08/2014
Cineworld Group (CINE)Travel & Leisure1282Buy - 25/08/2015
Intermediate Capital Group (ICP)Financial Services3276Buy - 20/05/2015
Lookers (LOOK)General Retailers1573Buy - 08/09/2015
Antofagasta (ANTO)Mining4286Buy - 25/08/2015
Pendragon (PDG)General Retailers214Buy - 05/08/2015
Royal Mail (RMG)Industrial Transportation5145Hold - 29/07/2015
Regus (RGU)Support Services1435Buy - 25/08/2015
Vodafone (VOD)Mobile Telecommunications6181Hold - 08/10/2015
Marshalls (MSLH)Construction & Materials1886Buy - 01/09/2015
Berkeley (BKG)Household Goods & Home Construction722Buy - 17/06/2015
Bellway (BWY)Household Goods & Home Construction1317Buy - 13/10/2015
Royal Dutch Shell (RDSA)*Oil & Gas Producers8226na
Booker (BOK)Food & Drug Retailers2288Hold - 15/10/2015
Royal Dutch Shell (RDSB)Oil & Gas Producers9229Buy - 30/07/2015
Amlin (AML)**Nonlife Insurance779Accept - 08/09/2015
John Wood Group (WG.)Oil Equipment, Services & Distribution1048Hold 19/08/2015
Betfair (BET)***Travel & Leisure18210Await documents - 26/08/2015

*Not included as we have the 'B' shares instead

**Will not be included due to stage of takeover bid

***Will not be included due to stage of proposed Paddy Power merger

 

Bottom quintile

NameSectorValue rankingMomentum rankingLast IC view
BP (BP.)Oil & Gas Producers43254Hold - 29/10/2015
Hargreaves Lansdown (HL.)Financial Services23643Buy - 9/09/2015
Renishaw (RSW)Electronic & Electrical Equipment44141Buy - 30/07/2015
Pets at Home (PETS)General Retailers11444Buy - 29/07/2015
Hiscox (HSX)Nonlife Insurance4558Hold - 27/07/2015
Telecom Plus (TEP)Fixed Line Telecommunications18545Buy - 24/06/2015
Shire (SHP)Pharmaceuticals & Biotechnology46266Hold - 5/08/2015
UDG Healthcare (UDG)Health Care Equipment & Services10946Buy - 21/09/2015
Land Securities (LAND)Real Estate Investment Trusts47116Buy - 20/05/2015
Laird (LRD)Technology Hardware & Equipment11347Buy - 3/08/2015
Workspace (WKP)Real Estate Investment Trusts4871Buy - 29/07/2015
RPS (RPS)Support Services4974Buy - 5/08/2015
Investec (INVP)Financial Services50239Buy - 22/05/2015
Synthomer (SYNT)Chemicals17550Hold - 12/08/2015
Tullow Oil (TLW)Oil & Gas Producers51287Hold - 29/07/2015
Bwin Party Digital Entertainment (BPTY)Travel & Leisure20151Hold - 2/09/2015
Rio Tinto (RIO)Mining52236Buy - 15/10/2015
Savills (SVS)Real Estate Investment & Services9552Buy - 7/08/2015
BHP Billiton (BLT)Mining53271Hold - 25/08/2015
Associated British Foods (ABF)Food Producers21653Hold - 8/09/2015