Getting your factors straight

James Edwards explains how investors can make sense of the many different multi-factor strategies on offer

James Edwards

Director, Sales, UK Institutional

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Risk Disclaimer

Past performance should not be seen as an indication of future performance. Stock market and currency movements mean the value of, and income from, investments in the strategy are not guaranteed. They can go down as well as up and you may not get back the amount you invest.

 

Views and opinions have been arrived at by BMO Global Asset Management and should not be considered to be a recommendation or solicitation to buy or sell any companies that may be mentioned.

 

The information, opinions, estimates or forecasts contained in this document were obtained from sources reasonably believed to be reliable and are subject to change at any time.

Factor investing has grown in popularity in recent years as investors seek low-cost ways to access well-understood drivers of return in markets. In response, the investment industry has seen an explosion in the number of factor investment products with “styles” and “smart beta” also used to describe the approach.

As diversification is the cornerstone of any strategy, it is perhaps therefore not surprising that a recent FTSE Russell survey found that multi-factor strategies have been the most popular approach for institutional investors around the world.

According to the 2018 Credit Suisse Global Returns yearbook, researchers have identified at least 316 factors that may drive markets. Whilst not all will stand up to independent testing, how are investors to make sense of what is on offer and the risks to which they are truly exposed with so many potential approaches?
 

Unintended consequences

 
Let’s consider the momentum factor as an example. Momentum is the tendency for rising asset prices to rise further and for falling asset prices to fall further, perhaps reflecting investors’ tendency to underreact to market moves. The momentum factor has had a strong run of performance: over the last 12 months to August 2018 the MSCI US Momentum index returned 28%, outperforming the standard US index by over 8.5%.

This isn’t a recent phenomenon however. Since 1994, the momentum index in the US has outperformed the market cap weighted index by 3.7% per annum. Whilst over the long-run momentum has performed strongly, it has seen some sharp reversals. Notably, momentum underperformed market cap weighted in 2008, and its maximum drawdown (peak to trough performance) during the financial crisis was almost 56%. What has driven the recent run of strong performance? The largest constituents of the US Momentum index should need no introduction comprising household names such as Amazon, Microsoft, Netflix, Intel, Visa and Mastercard. Indeed, the index has around 42% in Technology companies.
 

Buy… High? Sell Higher?

 
Momentum could be characterised as the strategy that buys high and sell higher, running counter to the classic maxim of buying low and selling high. It should come as no surprise then that the momentum factor is therefore underexposed to “value” companies (companies that look cheap or less expensive relative to some measure of intrinsic value).

Given that momentum is underexposed to value, what do the largest stocks in the MSCI US Enhanced Value index look like? Household names again, including Apple, Pfizer, Bank of America, Intel, Cisco and Citigroup amongst them. In fact, 12% of the index is Apple alone, with around 27% of the index represented by Technology firms.

It is clear therefore that stocks will often exhibit one or more factors due to the simple fact that the correlation of the company fundamentals used to construct a factor will not be zero. Because of these correlations, a simple combination of the most common and well understood factors may result in a portfolio with unintended exposures: a portfolio that does not differ much to the cap weighted index, or alternatively a portfolio with unintended concentration in particular segments of the market.

Risk Disclaimer

Past performance should not be seen as an indication of future performance. Stock market and currency movements mean the value of, and income from, investments in the strategy are not guaranteed. They can go down as well as up and you may not get back the amount you invest.

 

Views and opinions have been arrived at by BMO Global Asset Management and should not be considered to be a recommendation or solicitation to buy or sell any companies that may be mentioned.

 

The information, opinions, estimates or forecasts contained in this document were obtained from sources reasonably believed to be reliable and are subject to change at any time.

Use our handy glossary to look up any technical jargon you are unfamiliar with.

Related Capability

Style Investing

Styles come and go and but True Style is timeless

 
We are strong advocates of multi-factor approaches. We believe they fulfil an important role in pension fund portfolios and enable access to systematic return drivers at low cost.

We believe that insufficient attention is paid to the construction of the underlying single factors however. In a perfect world, the underlying factors would be entirely uncorrelated. Put another way, when constructing a factor, investors should adjust the underlying data for common factors, so that the end result is a pure or “true” factor.

Why does this matter? As noted earlier, the commonality across different factors means that the correlation between these “raw” factors may be high, making diversification more challenging. In the case of the momentum and value examples, we have the opposite problem: the strategies are almost entirely opposite, so a naïve combination of the “raw” value and momentum factors could end up with almost no difference in position versus the cap weighted index.

So, constructing a multi-factor portfolio with “true” styles should therefore offer better diversification versus market cap weighted portfolios and a more optimal combination of factors. The optimal portfolio should in turn lead to better risk adjusted returns in the long-run and therefore offer pension schemes a better chance of meeting their long-term investment objectives.