Multi-Asset

The Factors Speak for Themselves

As asset prices “decouple” in later stages of the economic cycle, the need for a broadly diversified portfolio grows stronger. Fred Demers, Director, Multi-Asset Solutions Team, BMO Global Asset Management, argues that traditional splits across asset class, geography, and sectors may not be enough to mitigate downside risk, and Advisors should instead consider a factors-based approach for better, more efficient diversification in their clients’ portfolios.
February 2019

Fred Demers

Director Multi-Asset Solutions, BMO Global Asset Management

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As asset prices “decouple” in later stages of the economic cycle, the need for a broadly diversified portfolio grows stronger. Fred Demers, Director, Multi-Asset Solutions Team, BMO Global Asset Management, argues that traditional splits across asset class, geography, and sectors may not be enough to mitigate downside risk, and Advisors should instead consider a factors-based approach for better, more efficient diversification in their clients’ portfolios.

 

Are your clients truly diversified?

Over the last few decades, a scientific consensus has emerged on the virtues of diversification. Virtually no one disputes the idea that pooling unrelated securities helps reduce downside risk, while preserving some of the upside. However, portfolio diversification is so common we often forget how challenging it is to achieve – especially in the modern era.

The fact is international capital markets are highly integrated. Traditional methods of reducing your clients’ volatility exposure, such as spreading investments across asset classes, geographies and sectors, do not always mitigate risk to the desired level. There is a misconception that holding more assets must equate to less portfolio risk, when in reality Advisors need to choose securities with indifferent or even negative relationships to each other. Even if you look at emerging markets, correlations are extremely high over a 12 to 18-month period, making it difficult to be effectively diversified.

In trying to reconcile these ongoing issues, and explore innovative ways to improve portfolio construction, we are adding a “factors” consideration to our investment philosophy.

 

What is factor-based investing?

Generally speaking, factors are specific attributes that can be used to group securities according to a shared characteristic. They come in two varieties: investable and observable. The former are fundamental drivers often found in equity valuation research, such as growth, value, low volatility, quality or dividend, and the latter consists of less tangible indicators, including gross domestic product and inflation. While not equally actionable, both have an enormous impact on asset prices and correlations over time.

Factors also allow us to decompose risk in more interesting ways. Rather than constructing an index using standard metrics like market cap or sector allocation, we can maintain broad market exposure, like any other balanced fund, and still tilt the portfolio towards a characteristic that fits the prevailing economic conditions.

Systematic Factors Definition Measurement
Value Stocks with low prices relative to their fundamental value Book to price, earnings to price, book value, sales, earnings, cash earnings, net profit, dividends, cash flow
Size Smaller firms (by market capitalization) relative to larger firms Market capitalization
Momentum Stocks with stronger past performance relative to weaker firms Relative returns (e.g., 3-mth, 6-mth, 12-mth)
Low Volatility Stocks with lower volatility, beta Standard deviation (e.g., 2-yrs), Beta to benchmark
Dividend Yield Stocks with higher dividend yields Dividend yield
Quality Stocks characterized by low debt, stable earnings growth ROE, earnings stability, dividend growth stability, balance sheet strength, leverage, accounting policies, strength of management, accruals, cash flows

Adding factors to the “Five Lenses” framework

To incorporate these characteristics into our proprietary “Five Lenses” investment approach, we merged the second and third lens, which previously encompassed stocks in developed and developing markets, and dedicated the fifth lens entirely to factors. The new format is as follows:

  1. Asset Allocation
  2. Equities
  3. Fixed Income
  4. Currency
  5. Factors

 

Adding to its many advantages, factors provide a tactical approach during times of slower economic growth. With the rise of exchange traded funds (ETFs) and ready-made ETF portfolios, rotating between factors to match the current economic regime has never been easier. Also, given that a decade-long bull market is currently winding down, and indiscriminate investment across asset classes has become dangerous, it seems logical to conclude that we are indeed entering a late-equity cycle, and investors will need to shift to a defensive stance soon – if not already.

 

Numbers don’t lie

It is important to remember that factors are not a silver bullet – like all other investments, they exist on a risk-reward spectrum. Some offer higher potential upside at the expense of greater volatility, others are more modest in their scope for returns. Depending on your clients’ financial goals and risk tolerance, you can decide what type of exposure is more appropriate. There is, after all, ample historical data on how factors perform across the economic cycle.

Average Monthly Performance Relative to Market Benchmark Since 2007 (MSCI ACWI)

The above chart compares average annualized returns for leading global equity factors to average annualized performance for the broader market, as defined by the MSCI All Country World Index. As you can see, Quality assets have had the best track record since 2007, outperforming the benchmark on average by 20 basis points per month. Momentum and Growth followed closely behind, while defensive factors like Value and High Dividend yielded quite poor results over the same time period, in essence proving these factors have low-to-negative correlation.

When your clients’ portfolios are tested by market turbulence, the diversification benefits will become incredibly clear. For example, the below chart looks at performance when the benchmark has fallen by at least 1% in a month. Predictably, it shows outsize success for defensive styles – such as Quality and Low Volatility – during moments of massive sell-offs. Low volatility stocks in particular carry a 200 basis point advantage on average compared to other styles.

Average Relative Monthly Performance When Market Down More Than 1% (2007-2018, MSCI ACWI)

Which factors are useful today?

With the Federal Reserve (Fed) taking a more cautious tone in recent weeks, high-dividend equities are starting to look quite interesting. It was a turning point to see Federal Open Market Committee Chairman Jerome Powell say, “the case for raising interest rates has weakened somewhat,” given how recently he assured markets there was adequate runway for three or four rate hikes in 2019. In choosing to leave the Fed funds target rate at 2.25% to 2.50%, Powell effectively confirmed a drop in growth expectations and laid the groundwork for a more accommodative stance should there be larger-than-expected fallout from the China-U.S. trade war or ongoing U.S. budget deliberations. Ultimately, the combination of benign interest rates and lower volatility could serve as a tailwind for equities yielding a higher dividend.


To learn more, read our whitepaper on Dividend Investing with Covered Calls.


The same stands true for Quality stocks with minimal debt-to-equity, a stable earnings profile, impressive return-on-equity, solid cash flow and strong management. Typically, companies with these characteristics provide better relative value under stress than the type of procyclical Growth assets investors like to hold during the boom times.

For a complete look at our Five Lenses output, see below.

Lenses Key Influences
1. Asset Allocation
  • Steady overweight equities relative to bonds as earnings growth in the U.S. remains healthy, albeit slowing.
  • Scope for an extended pause by the Fed in 2019 would benefit risk assets.

 

Decision: Remain underweight fixed income and overweight equities.

2. Equities
  • No strong preferences outside of the U.S.
  • A more dovish Fed removes a key cyclical headwind to Emerging Markets, but Chinese economy showing signs of pain from trade wars.

 

Decision: No change in portfolio tilts.

3. Fixed Income
  • The pace of monetary policy normalization will slow in 2019.
  • Although we might not see another rate hike in Canada or the U.S. before the summer, we doubt we have seen the peak in policy rates yet.

 

Decision: Remain moderately underweight duration and credit.

4. Currency
  • The Canadian economy is facing several headwinds. Lower oil prices, a consumer debt overhang, and higher interest rates are limiting growth for 2019.
  • The loonie will remain under pressure although the US dollar is probably near its cyclical peak.

 

Decision: Canadian dollar upgraded and the Japanese Yen downgraded to neutral.

5. Factors
  • Late cycle favours more defensive dividend stocks.
  • Trade wars should impact small caps less than large firms.

 

Decision: Remain underweight fixed income and duration and overweight high dividend.

Expanding the menu

As ETFs and ETF portfolios accrue a greater proportion of investment dollars, there is greater demand for diversity in index construction. Not everything needs to be based on market cap weightings; in fact, breaking assets down by their underlying drivers can help you laser-focus on the sources of return in your clients’ portfolios. We are continuing to grow our selection of factor-based ETFs in order to make it easier to build tailored investment solutions and capture the benefits of diversification – that elusive advantage finance legend Harry Markowitz called, “the only free lunch in investing.”

To learn more about BMO Global Asset Management’s Enhanced Dividend Funds, contact your Regional Sales Representative.

For additional insight into our strategic portfolio allocations, and the secular trends expected to drive the global economy and markets from 2017 to 2022, click here to access the full BMO Global Investment Forum Five-Year Outlook.

For more on BMO’s “Five Lenses” Strategy, read our Q1 2019 Strategy Factsheet.

For more insights from the Multi-Asset Solutions Team, read our January 2019 Monthly Commentary.

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