IPE asked two European institutional investors what biases are built in their equity portfolios, as value equities show signs of new-found strength
Equal factor weights are best
We only have a small overweight to the value factor in our equity portfolio. We have a long history of investing in equity factors. In fact, our factor exposure is effectively a component of our strategic asset allocation. For any factor or asset class to become part of our asset-allocation strategy, it has to pass a set of quantitative and qualitative requirements, including our comprehensive ALM [asset-liability management] process.
Our equity portfolios are all managed passively and based on custom benchmarks. Our managers’ job is to replicate those benchmarks.
Across all regions except Switzerland, we have a 50% allocation to the standard index. The remaining half of the portfolio consists of equal allocations to small caps, enhanced-value and minimum-volatility indices. Due to the narrow and concentrated equity universe in Switzerland, which makes factor investing particularly challenging, we implemented an all-cap strategy for our domestic equity market.
Holding 50% of the standard index is a way to limit tracking error of the overall, blended strategy. The equal weighting of the other three components – small caps, enhanced value and minimum volatility – is there because we do not formulate a tactical, short-term view on individual factors.
Statistics and game theory tell us that an equal allocation between those different strategies is the optimal strategy in the absence of a-priori assumptions or estimates. We found good evidence of that by running several simulations of our portfolio.
The portfolio, which is rebalanced every six months in sync with the semi-annual index rebalancing of our index provider MSCI, has a very similar risk profile to the standard index but provides us with the potential of a moderate pick-up in returns.
We allocate to factors like value because we find both the underlying financial theories as well as the return history compelling. Even though the academic discourse on value is not necessarily conclusive, there are sound econometric and behavioural theories that explain its existence.
Growth stocks have seen a tremendous run, not only during the past year. At the same time, valuation differentials between value and growth stocks have peaked at all-time highs. Based on contingent factors, cyclical value stocks can start to pick up quickly and suddenly growth stocks become less interesting.
The case for value is strong
We normally have a large exposure to equities. On average, it is about 50% and currently stands at 60% in terms of listed equities and 10% of unlisted equities, which mainly consist of infrastructure, plus a small share of private equity.
We do not have structural bias towards a particular style or geography. Currently, however, we are significantly overweight towards emerging market equities and Japanese equities. The allocation is roughly 18% to emerging markets and just over 12% to Japanese equities. We also have positions in European equities and US equities, but they are not that large, relative to the main indices. The allocation is around 14% of the portfolio for both regions.
In almost all regions, we also have a significant bias towards value equities at the moment. We started to implement that bias over the course of last year, with a very small exposure initially, and we ramped up the allocation at the end of last year. Around 80% of our European equity exposure is towards value or deep-value funds. The factor accounts for around two-thirds of our US equities. Most of our Japanese equities are value equities. Because it is harder to implement a value bias in emerging market equities, only around one-third of our portfolio is made up of value equities.
There are several reasons for our choice to implement a value bias at the moment. In the first instance, we did it to dial down our exposure to growth equities. Rates have started rising and this can have a very negative impact on growth equities. A bias towards value is, therefore, a way to reduce the downside risk and volatility. Growth has had a much higher volatility than value over the past few months, which is a new development, and the opposite that has happened over the past decade.
We expect that, due to the base effect, the near-term growth of many cyclical indicators will be very strong. Revenues of cyclical stocks have been depressed throughout 2020, and it is reasonable to expect growth of more than 20% in many cyclical sectors. This could spark a very impressive repricing of value stocks, which will look cheaper and more attractive than growth stocks.
Some of the growth stocks could experience slower revenue growth as the COVID-19 emergency ends. When the traditional sectors of the economy reopen, internet-based economic activity could slow down and experience a partial return to the mean.
We do not have any hedges in our equity portfolio at the moment. That is something we do opportunistically. In the past, we have bought call options on the VIX, which can be very profitable when volatility is depressed. At the moment, the VIX index is rather expensive.
In general, we are positive on equities because of the wall of money created by central bank policy in the past year. However, we do expect to reduce risk in the portfolio during the second or third quarter of 2021. We will do that by replacing equities with absolute-return funds. Our allocation to absolute-return strategies stood at 25% of the portfolio until about three years ago. Now it is down to 10%, but we expect to raise it as a defence against equity drawdowns.
Interviews by Carlo Svaluto Moreolo