Blend the right factors and styles for better returns

Market factors relate to the broad reasons for market rises and falls, rather than stock-specific reasons. And an investment style involves supporting a particular type of stock that can perform differently to, and sometimes better than, the market as a whole. Together, they are known as risk premia – a very specific type of risk which, when embedded in a portfolio, leads to better returns over the long term. Examples of market factors include momentum and minimum volatility, and examples of investment styles include value, quality and growth, as set out in table 1

 Table 1: Factor definitions

Certain market situations favour one style or factor over another, and as the equity volatility of 2018 might continue this year, it is probably a good time to ensure that investment portfolios have exposure to both growth and defensive factors and styles, tilted to the right areas at the right time.

Before doing this you should first look at when certain styles and factors did well in previous years, and why this was the case. The table below shows which styles and factors made the best returns for MSCI World index over the past 10 years.

Table 2: Investment style performance

Source: FE Analytics

Table 3: How style and factor indices performed in 2018

Source: FE Analytics

Although over the past decade investors have been more interested in growth stocks, the ones with the lowest volatility have outperformed most frequently. To get exposure to these you need to invest in stocks, or funds that hold stocks, whose share prices have moved sideways over the long term – rather than up and down frequently and aggressively. It is not surprising that such a strategy outperformed in 2018, given the rapid change in market direction from quarter to quarter, and a significant sell-off in growth stocks such as technology companies. Momentum investing, which involves buying more stocks that have recently risen, did well in 2017 probably due to the performance of growth and tech stocks.

Nick Peters, multi-asset portfolio manager at Fidelity International, says: “Over the past five years the style that has worked best is growth in relative terms, companies that display strong growth dynamics in terms of revenue and profit, and those with strong balance sheets. This is mainly because as rates were cut and concerns about economic growth increased, investors were more comfortable investing in these stocks. But in the past six months volatility has picked up and there is uncertainty about growth. Some people were concerned that it would be too strong, meaning that interest rates would rise more aggressively, and others were concerned that growth was too tepid and that we have a recession on the horizon, which has brought the growth style into question.”

How styles and factors are related

When deciding how to position investment portfolios in 2019 and before the upcoming change in market conditions as we approach the end of the business cycle, it is useful to look at which types of stocks have done badly when others have done well. Value has been the worst performing style or factor most frequently over the past 10 years, minimum volatility did badly when growth and momentum did well, and value did badly when minimum volatility did well. And although growth has been the star performer for the past 10 years, it was the worst performing style when value was the best performing one in 2016.

But while it’s helpful to see what has done well and what hasn't, a portfolio should have exposure to all options with tilts to specific styles and factors at the margin.

Ben Seager-Scott, chief investment strategist at wealth manager Tilney, says it is difficult to time factors and styles, and that you shouldn't make short-term calls. But he adds that “it is worth considering what market conditions tend to favour different styles, and then considering the outlook”.

For example, a value investment style works best when markets are recovering from a shock as discounts become stretched, but it tends to underperform in bear markets. “Although many investors think stocks already trading at a discount would effectively have a margin of safety, the sector composition typically gives greater exposure to financials, which can underperform in a downturn,” explains Mr Seager-Scott.

Momentum works better when investors are optimistic and in bull markets because they run the winners. But momentum can vastly underperform when a market corrects or in times of volatility. Factors such as low volatility and quality tend to be more defensive, while quality, which focuses on companies with low debt and stable earnings, does well when markets are falling and underperforms when they are rising.

Ryan Paterson, head of research at wealth firm Thesis Asset Management, adds: “Different environments favour different factors. The low growth environment rewarded companies with high-quality revenues and investors have been willing to pay a premium [for them]. Value does well when there are expectations of high growth, and has struggled since growth has been quite sanguine."

How they could perform

Given the correlations and collaborations discussed above, some styles and factors could do better, although all come with caveats. Momentum had a relatively good 2018, with MSCI World Momentum index rising 3.3 per cent versus a 3 per cent fall for MSCI World index. However, it really struggled in the final three months and has seen its composition change as momentum backs the stocks that have performed best most recently. This index now includes more healthcare and utilities companies, although still has a 25 per cent weighting to tech stocks.

However, Simon Whiteley, a senior quantitative investment strategist at Aberdeen Standard Investments, says momentum looks expensive as a factor. “That might be a headwind in 2019," he says. "When there’s a rotation it can be very difficult and violent. It is a risky factor, where the turnover can be high as there is constant change in stock composition. But momentum is very much a risk premium, so over the long term provides excess return."

Mr Peters adds: "Once volatility starts picking up momentum is difficult to identify. You need to wait for market rotation to take place and then feed money into that momentum. When volatility is high, markets are choppy, everything is uncertain and you do not want to go near it."

Minimum volatility was the best performing factor in 2018, with MSCI World Minimum Volatility index rising 4.1 per cent versus a 3 per cent fall for MSCI World index. “It is still an attractive factor," says Mr Whiteley. "However, if there is not an economic and market slowdown, and there is economic growth, minimum volatility will underperform the main index. And if you believe that things will deteriorate then quality will do well.

However, Mr Peters suggests minimum volatility is ripe for profit-taking as it did well in 2018, and is focusing on value. “We have been investing small positions in value managers and, as our conviction grows, will add to them more aggressively,” he says. “It is very difficult to identify a catalyst, but I think the valuations of both growth and value stocks are such that it is sensible to take money away from the former and add to the latter. At some point you will see a rotation – it’s difficult to say when, but in a long-term plan you should be rotating.”

Quantitative investment theory suggests that value investing outperforms over the long term because you buy beaten-up stocks that have underperformed and then mean-revert.

"Value investing has had a terrible time, but we believe the value thesis is not dead," says Mr Whiteley. "It’s a high-risk factor, but is always cheap and relatively cheaper on a global basis. When value snaps back it will do this quite quickly.”

However, some investors argue against tilting a portfolio to only one factor, and favour building and maintaining a portfolio exposed to all factors and styles as this adds in diversification. For example, value and momentum both outperform the market average over the long term but are not correlated. Value stocks have poor momentum, and momentum tends to mean buying increasingly expensive stocks, so having both diversifies a portfolio. Similarly, holding value and quality or growth stocks at the same time offers diversification benefits.

“It’s very difficult to identify other [biases] as these would be arbitraged away by the market," says Andrew Gilbert, a portfolio manager at Parmenion. "But value can be interesting when blended together with other styles which may have more of a quality/growth/capital preservation approach as this caters for a variety of macro and political scenarios. Low-volatility strategies tend to outperform in bear market conditions and can underperform if sentiment improves significantly. This is precisely why you need to have a blend of styles within your portfolio.”

Funds to factor in

To get access to specific factors investors can put their money into quantitative funds, which are run using algorithms that weight them to stocks with certain characteristics. These are also known as 'smart beta' funds and are often exchange traded funds (ETFs).

One option is UBS FTSE RAFI Developed 1000 Index (GB00BX9C1L56), a passive open-ended fund. This follows a contrarian and mean-reversion strategy that leads it to value stocks in global developed markets. It tracks an index whose holdings are selected according to fundamental factors such as sales, cash flow, book value and dividends, and weighted accordingly. This is in contrast to traditional mainstream indices which are market-cap-weighted – biased to the largest stocks by market cap value.

FTSE RAFI Developed 1000 Index rebalances every quarter and, because it uses book value as a metric, sells stocks after the price increases and reinvests in lower-valued stocks. This index has different weightings to the market-cap-weighted FTSE Developed All Cap Index on which it is based. FTSE RAFI Developed 1000 Index has greater weightings to Japan and Europe and less to the US, and greater weightings to banks and oil stocks and less to industrial and tech stocks. UBS FTSE RAFI Developed 1000 Index Fund has an ongoing charge of 0.3 per cent.

iShares offers several ETFs that track MSCI factor indices. These include iShares Edge MSCI World Minimum Volatility UCITS ETF (MINV), iShares Edge MSCI World Quality Factor UCITS ETF (IWFQ) and iShares Edge World Momentum Factor UCITS ETF (IWFM). These have an ongoing charge of 0.3 per cent. 

Table 4: Fund performance

Source: FE Analytics, as at 04/02/2019, *since launch 01/08/2016