Russell Taylor: Style rotation no substitute for sound returns

Russell Taylor: Style rotation no substitute for sound returns

Smart beta has proved a great selling point for canny investment managers. All told, some $1trn (£722bn) is estimated to be invested in a variety of systems designed to beat the market by identifying the ‘factors’ that are – or, at least, seem – important to outperformance. They include metrics such as size, value, yield, low volatility and momentum. 

Does factor investment work?

Now those tireless investigators of all things financial [specifically, in this case, Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School, in an article in the Journal of Portfolio Management] have investigated the what and the why of factor investing. 

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It does seem that 40 years of share price history supports the theory – but not always reliably. There are years when these factors do not deliver.

The ‘why’ could yet prove a question without a suitable answer. Are the higher returns associated with certain factors the reflection of greater risk? 

Smaller stocks are more expensive to manage, and much less liquid and so riskier in a downturn. Value stocks may look cheap, but that valuation may also reflect a more dangerous business environment. 

Or perhaps those higher returns have more to do with the behavioural biases of the managers. Some managers are quicker to discern that business conditions have changed, and a company’s outlook has developed for the better. As others follow these leaders, so momentum builds. Hence crowd-following tendencies can lead to overpricing of high-volatility shares, with their relatively less exciting opposite numbers benefiting from a return to investment sanity.

The important question

Before private investors jump into the Oeics and ETFs that are promoting such methods, they need to ask themselves just one question. Does such an investment style protect their hard-earned and absolutely essential capital? More specifically, perhaps, did this investment style protect them when markets turned mad at the beginning of February?

The brutal truth of investment mathematics never changes – a sudden fall in a share price can result in a 50 per cent loss of capital, which then requires a doubling of what remains merely to get back to the original starting point. Moreover, these temporary market shocks seem to affect prices in a perverse way: the share that has fallen by 50 per cent never seems to be the one that recovers. The reorganisation of a portfolio in acceptance of the new market reality brings further risks of its own.

Do capital gains exist?

Despite investment managers’ promises to the contrary, there is no such thing as a ‘capital gain’, although there are certainly ‘dealing’ gains. Report after report shows that it is compounded dividends that produce the capital gains of a portfolio, while compounding, in this context, arises from a portfolio managing to avoid losses. 

The lower the loss, the greater the overall gains over the life of the investment. Indeed, this finding was one of the most important of the previous studies conducted by Mr Dimson and Mr Marsh some decades ago.

Investors have a choice. They can be ‘dealers’ – buying and selling individual shares or bonds as the mood takes them – or investors. If the latter, then their choice is between active or passive investment in the markets of their choice – domestic or global, blue chips or smaller companies, generalist or specialist, consumer markets or technology, or as many sectors as fund managers can dream up.