Institutional investors have adapted their asset allocation to a changed market environment in recent years. Persistently low interest rates and volatile equity markets have had an impact on the assessment of the risks associated with passive and fundamental investment strategies. While passive strategies inevitably increase market risk in times of rising volatility, it has become increasingly challenging for fundamental-based asset managers to consistently outperform their benchmarks. Both approaches will continue to have their place in the portfolios of professional investors. However, the role of factor-based strategies as a third pillar is likely to grow in order to contribute to generating consistent, predictable outperformance.
Multi-factor strategies contribute to portfolio diversification and thus to risk reduction.
Yet for many investors, this raises questions: What factors should we focus on? How stable are the negative correlations between different factors? Can factor strategies sustainably generate alpha?
Looking back shows that the basis for factor premiums is scientifically and empirically sound. A practical look helps to better understand how factor-based strategies can work in the portfolio context. These strategies are not a panacea, but when used correctly, they help improve portfolio efficiency significantly.
The myth of market efficiency
A hallmark of classical capital market theory is the linear correlation between risk and reward. That higher returns can only be achieved through greater risk is so intuitive that it is a part of almost all standard curriculums, in spite of its extremely restrictive basic assumptions. For it to be true, however, a perfect market is required, on which rational investors trade homogeneous goods without spatial, temporal or personal preferences, and without transaction costs, taxes or other market barriers, all against a backdrop of full market transparency. With his Efficient Market Hypothesis (EMH), Eugene Fama subsequently put out the myth that markets worldwide are efficient. Yet, doubts soon emerged on whether markets were truly efficient. Anomalies such as calendar effects and speculative bubbles could not be reconciled with the EMH. As far back as the 1980s, Robert Shiller thought that the EMH did not stand up to empirical evidence:
“It should be obvious to the most casual and unsophisticated observer by volatility arguments like those made here that the efficient markets model must be wrong … The failure of the efficient markets model is thus so dramatic that it would seem im-possible to attribute the failure to such things as data errors, price index problems, or changes in tax law.”
(Robert J. Shiller, « Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends? » ; The American Economic Review, juin 1981, p.421)
What is factor investing?
Factor-based investment strategies focus on characteristics of securities, the so-called factors that explain differences in returns. Factors that demonstrably have achieved higher risk-adjusted returns than the market average include the size of the company, the market valuation, recent price trends of a stock (momentum) and high dividends. By selecting securities based on factors, investors aim to outperform markets in the long term. Asset managers using a factor-based approach do not let themselves be guided by their own opinion or speculations about a specific stock. Instead, their investment decisions are always based on quantifiable facts and data.
Value – a proven recipe for success
Long before academics did so, market participants doubted the existence of efficient markets. Benjamin Graham’s watershed work The Intelligent Investor was published as far back as 1949. It was based on the premise of investing in companies that are trading below their real value. The underlying assumption that the market does not always reflect a company’s true value stands in direct contradiction with the EMH. Graham thought that markets tend towards overshooting or undershooting and that prices approach fair value only over time. He put a face on the market, whom he called “Mr. Market” and whom he described as manic-depressive. He is not rational but is driven by emotions, offering to buy shares one day and sell them the next. The Intelligent Investor stands ready to exploit Mr. Market’s moods. The Intelligent Investor suppresses his own emotions, buying from pessimists (at excessively low prices) and selling to optimists (at excessively high prices).
Graham’s investment philosophy was based mainly on his observation of historical P/E ratios, in which companies are often chosen that have performed poorly recently and are therefore cheap. Such shares tend to be more volatile and to have a beta over one. Things often get worse before they get better. Deep-value strategies, which invest in such turnaround stories, may be a good idea but they often result in high drawdowns.
Dr. Carsten Große-Knetter
Global Head of Quantitative Equity, ODDO BHF Asset Management
Portfolio Manager, ODDO BHF Asset Management