Speaking with clients, colleagues and peers over the past couple of months, there seems to have been a lot of renewed interest in factor-based investing.
Part of this is likely to have been driven by the growing awareness of factor-based ‘smart beta’. At the same time, market movements in the past few months have been perceived as being a shift from growth stocks to value stocks, tempting many to try and time the market – a hazardous exercise at the best of times.
There are a lot of interesting discussions to be had about factors, such as which ones represent genuine risk premia, which are more closely linked with behavioural anomalies, and which will persist in the future – and over what sort of time frame. Many view factors as being new concepts in markets and novel ways to invest, but in many cases we’re simply explicitly recognising something that has always been there and investors have already been benefiting from in one way or another.
Almost by definition, factors have always been a part of markets. Like atoms, they have existed as fundamental elements of the wider whole, and only more recently have some been isolated and identified as distinct return drivers, or at least historical patterns. Those factors that are well established, grounded in rational market theory and based on decades-old research – such as value investing – have been used explicitly in the institutional world for a number of years, despite being relatively new products in the retail space.
Even within the retail market, many of the established factors – usually referred to as ‘styles’ – are implicitly a part of client portfolios through traditional active managers with an apparent style bias, who add value through stock selection as well. While it can be frustrating listening to some managers claim credit for stockpicking in the good times and blame style drags for performance in bad times, the truth is somewhere between the two. Styles will often act as both a headwind or tailwind which should be considered in conjunction with other aspects of particular managers’ process, not in isolation.
Markets are complex and chaotic, and it is a natural instinct to try and impose order and simplicity. But it is a mistake to assign too much trust in the short-term predictive power of individual factors.
Take the idea of looking at global equity markets simply through the lens of value and growth. In the past couple of months it appears that value stocks have started outper-forming growth. Is this because investors collectively decided that they’re now more interested in stocks that appear to be trading fundamentally below their intrinsic value, rather than those whose future growth is being mispriced?
Perhaps. It is more likely that sectors such as financials have had a boost from the election of Donald Trump and the prospect of less regulation and rising interest rates – sectoral, rather than factoral – though I hasten to add this is already fading.
To the extent that they have an appreciable rationale and supportive empirical evidence, factors can be useful as part of a long-term strategy, and most investors probably already have factor exposure implicitly through style bias in their active managers.
Factors can be a useful analytical tool to aid our understanding of investments, but they have little value as timing tools or as replacements for a well-thought-out, holistic investment strategy.
Ben Seager-Scott is head of investment strategy and research at Tilney Bestinvest
