Strategy: Factor rotation hits record pace
Tilting between factors could work well in this environment
- The spike in volatility at the end of 2018 saw investors switching factors at an unprecedented rate
- Will 2019 see the return of value investing and can it be sustained?
- Diversification remains the mantra as timing factors is always difficult
- While some advocate tilting to defensive strategies if volatility spikes, many are negative and see it as a form of timing
The prevailing wisdom is that factor investing is for the long haul but if recent investor behaviour is anything to go by, panic can still trigger short, sharp moves. The spike in volatility late last year is a case in point, although investors changed factor gears at a much faster rate than in the past. While the future is hard to predict, the ride in 2019 is set to be equally as bumpy.
“The speed of rotation in 2018 was unprecedented,” says Hitendra Varsani, executive director, equity core research at MSCI. “There were several events that happened at the same time – trade wars between the US and China, uncertainty over Brexit and concerns over the slowing of global growth. They amplified market moves and during the fourth quarter there was a clear shift to defensive sectors such as minimum volatility and quality, and away from cyclicals and value stocks.
In other words, a risk-off environment. Overall, in 2018 stock markets turned in their worst performance since the financial crisis, plunging between 15% to 25% across the regional and global boards, erasing nearly $7trn (€6.2trn) in gains.
More specifically, the MSCI European benchmark plummeted over 14% and the All Country World index (ACWI) slid almost 9%. Meanwhile, the Dow fell 5.6%. S&P 500 dropped 6.2% and the Nasdaq fell 4%. It was the only the second year that the Dow and S&P 500 fell in the past decade.
On the factor front, minimum volatility, which historically does well in stressed environments, ended the year as the best performer, scoring an 8% increase over the MSCI ACWI while momentum was up 4.4%. Momentum had had been leading the pack for most of 2018 but struggled in the final stretch. Quality returned 2% against the benchmark, while value and size were down 5.3% and 4.6% respectively.
Fast forward to 2019 and markets rallied strongly, restoring roughly $9trn (€trn)to global equity valuations in the first eight weeks. “One of the big issues in the fourth quarter of 2018 was tightening US financial conditions and China growth slowdown, whipsawing investors’ risk appetite,” says Marlies van Boven, managing director of research and analytics at FTSE Russell. “The FTSE Russell 2000 index had the biggest sell-off since 1986, down 20%, as investors poured into large-cap defensive stocks. In Q1 2019 came the largest rebound in the index (up over 10%) as the US Federal Reserve has adopted a more dovish stance, risk aversion resided and small-cap stocks were back in favour. Defensive low volatility, meanwhile, dripped across developed markets.”
Few, though, are willing to predict how the rest of the year will unfold. Markets may have recovered but last year’s scenarios are still playing out on the world stage. Geopolitical pressures continue with Brexit and more recently between India and Pakistan over Kashmir, while China and the US are still battling over tariffs. Moreover, the International Monetary Fund recently cut its estimates for global growth to 3.5% this year and 3.6% for 2020. These are 0.2 and 0.1 percentage points below its last forecasts in October – making it the second downward revision in three months.
“None of the stories from last year are finished but timing the market and factors is difficult because of the behavioural aspects, says Michael Rhodes, vice-president in GSAM’s quantitative investment solutions team.“If you look at this year, many investors fear the cycle is ending and logic would have quality companies continuing to outperform but, as we have seen in January, value was the best performer. Overall, a period of higher volatility in markets is certainly possible. Geopolitical risk has been running high. The VIX index has been abnormally low, particularly in 2017. Recent market volatility has been more in line with historic norms of VIX from 15-20.”
One of the biggest questions this year, given value’s recent resurgence, is whether this is a blip or whether the end is still nigh. Over the past decade, there have been countless articles predicting the demise of the value-factor strategy. Pioneered by Eugene Fama and Kenneth French, the style that comprises buying stocks with the lowest valuations and selling those with the highest (see article in this report, ‘Contrasting approaches’), has generated a cumulative loss of 15% over the past decade, according to research from Goldman Sachs. This has been the longest dry spell since the Great Depression of the 1930s. By contrast, in the same period, the S&P 500 rose by two-thirds.
Yazann Romahi, chief investment officer, quantitative beta strategies at JP Morgan Asset Management says the death knell should not be rung and that the strong performance of its value strategy in January was not a one-off. He notes that while value stocks are, by definition, cheaper than their more expensive/growth counterparts, the gap in valuation rose to the 93rd percentile, relative to 28 years of history, over the fourth quarter. Historically, when the factor has been this cheap it has delivered average returns of 15% over the next 12 months and been positive more than 70% of the time.
“There are those who have used this value drawdown to claim that value is dead and point to the fact that traditional measures of value (like price-to-book) focus on tangible assets, rather than intangible,” Romahi adds. “However, other measures of value like price-to-earnings and price-to-cashflow are not limited to tangible assets and their drawdown has been in line with price-to-book.”
Romahi is not alone in his views and some say new criteria should be applied to evaluate value. This is mainly because of the economy moving to a digitised and service-orientated model from an industrial framework where factories, real estate and machinery were the important assets.
Although there has been a greater focus on value’s performance, most fund managers eschew a single-factor approach. They advocate constructing a multi-factor diversified portfolio and 2019 is no exception. “It is the best way to navigate the markets,” says Bruno Taillardat, head of smart beta and factor investing at Amundi Asset Management. “We do not have a crystal ball and the level of uncertainty makes it very difficult to have the right call. You can use data mining to find a whole host of different factors but we look at the classic five – momentum, size, value, quality and low volatility.”
He notes that since there is no guarantee that all of them will continue to do well, it is important to ensure that each factor has a sound economic rationale and that they exhibit different characteristics and behaviours in order to build a robust and well-diversified portfolio.
Guillaume Garchery, head of quantitative research and development and a senior portfolio manager at La Française Investment Solutions, also does not accept that factor timing can add value. He says that even if robust explanatory variables were identified, associated transaction costs of entering and exiting premia in line with a timing-based strategy would likely be prohibitive.
While most agree that timing factors is difficult, there is more of a debate over fine-tuning the positions in the portfolios. Some say that a tilt towards defensive factors, for example, may help protect against further downside risks if, for example, 2019 proves as volatile as anticipated.
Ronen Israel, principal of AQR Capital says: “Tilting is mainly a euphemism for timing. Making small adjustments at the margin is not an outlandish idea, but it should be no more than that. There is not a lot of evidence to support that there is a great deal of benefit from tilting.”