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Factor investing in equities: Lessons from the COVID-19 crisis

Blog, Investment strategy

Daniel MORRIS
 

For many reasons, 2020 is already an exceptional year. Above all, the COVID-19 virus has shown how vulnerable the world is to a pandemic. To prevent a potential economic slump, the ‘whatever-it-takes’ response from central banks has been the fastest ever seen. Stock markets have rallied in reaction to the liquidity injections. While the major equity indices are now back, or close, to their levels at the start of 2020, the rally has raised questions about this exceptional drawdown and rebound.

Since the start of 2020, investors exposed to multi-factor equity strategies have suffered some underperformance. Investors with a long-term investment horizon can view this as a ‘short-term’ event.

When researching, designing and implementing systematic and factor investing strategies, we always consider short-term events as exceptional and non-predictable. Nonetheless, the COVID-19 crisis is an opportunity to review, confirm and, if necessary, improve the factor investing strategies we manage.

The reasons behind recent underperformance of multi-factor equity strategies

In recent years, multi-factor equity strategies have suffered from poor performance relative to cap-weighted indices. The market turbulence of 2020 has exacerbated this. In explaining this underperformance, we see a number of contributory factors:

  • The ongoing lagging performance of value stocks versus quality and growth stocks. The value underperformance cycle is now the longest ever observed. Multi-factor equity strategies seek to exploit the value factor. Their exposure to value has detracted from their performance in recent years.
  • Diversification and risk control considerations mean most multi-factor equity strategies underweight large and mega-cap stocks. This underweight has included the large information technology stocks in the US market. Their outperformance has been a feature of equity markets in recent years and again during the COVID-19 crisis. These underweights have therefore detracted significantly from performance given the strong outperformance of large-cap stocks relative to small caps.
  • Finally, multi-factor equity strategies can run significant stock and sector deviations compared to the traditional market-cap indices. For instance, these strategies were significantly overweight financials, industrials and consumer staples. They also held large underweights in the IT and communication services sectors, which detracted from performance.

Our multi-factor equity strategy seeks to tilt portfolios towards the cheapest (Value), the most profitable and best-managed companies (Quality) with the lowest risk (Low Volatility) and strongest trend (Momentum).

Recently, exposures to these factors did not generate the expected performance. Short-term outperformance was concentrated in specific stocks and sectors which were not well ranked from a factor perspective.

We believe in the long-term, sustainable outperformance of factors

Our multi-factor equity strategies have been designed to improve the long-term risk/return profile of investments previously managed against traditional market indices. In the research phase, we carefully selected factors with the characteristics described in Exhibit 1.

Exhibit 1: 

graph-1-multi factor equity

We believe that market inefficiencies explain the existence and persistence of factor premiums in financial markets. Determining the exact reasons for their existence is not straightforward as there are a number of plausible explanations. These include:

  • Market structure: Some structural characteristics of financial markets can explain inefficiencies – hence the existence of sustained sources of alpha.
  • Investor behavioural biases: Investment decisions may be impacted by human behavioural traits.
  • Investors’ constraints: Market inefficiencies can also result from specific constraints on investors. These may include restrictions on the use of leverage, selling securities short and/or low tolerance for turnover in a portfolio.

Exhibit 2 shows periods of underperformance for each single factor, especially Value, in recent years. These are mitigated through their risk-weighted combination in a multi-factor framework. Clearly, factors may be subject to short-term disturbance, but in the long run, the combination of factors such as Quality, Low Volatility, Momentum and Value does deliver sustainable outperformance, especially when they are blended in an efficient portfolio construction framework.

Exhibit 2:

graph-2- multi-factor equities

As such, we reaffirm our conviction that our multi-factor strategies have the potential to deliver long-term sustainable outperformance while at the same time controlling investment risk and integrating sustainability and carbon reduction objectives.

Benefits of continuous, robust research

Our quantitative equity investment team works closely with our Quantitative Research Group to constantly review, affirm and improve our factor investing strategies. A strict governance is applied based on three-year research cycles.

The current research cycle (the fourth of its kind) was launched in 2018, meaning that as of today we are in the middle of this new cycle. This current cycle is expected to lead to a number of improvements to the methodology. The investment philosophy will of course be maintained. We remain highly confident in our ability to deliver positive alpha over the medium to long term.

Exhibit 3:

graph-3-cycles-investing-research

Under the current research project, we are reviewing the investment process, breaking it down into four main areas:

  1. Factor definitions: We believe our four styles of factors are sustainable alpha engines (Value, Quality, Momentum, Low volatility). In each cycle of research, we review and enrich the list of indicators used.
  2. Risk model: The risk model will integrate the factor definitions to introduce consistency with the alpha model and increase the robustness of the portfolio construction.
  3. Portfolio construction: The research objective is to reduce the impact of portfolio constraints on the targeted exposure to factors.
  4. Factor attribution: The goal is to use the contributions from the four factors to explain the excess return of the strategy.

The COVID-19 crisis offers an opportunity to reinforce our research efforts

We will continue to refine and develop our multi-factor equity strategies over the coming years to deliver their three investment objectives:

  • Sustainable outperformance
  • Strong risk controls
  • The integration of sustainability goals.

As such, while 2020 will go down in history as the year of the COVID-19 pandemic, it will also be the year in which we further developed our research efforts in these key investment strategies.


Disclosures

Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients.

The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.

Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).

Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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