Risk & Portfolio Construction: Always in style
Four or five equity-investing ‘styles’ appear to be systematically rewarded over time.
Maha Khan Phillips asks if it is possible to use them to diversify a long-only portfolio
The financial crisis put paid to the idea that effective diversification occurs simply through the use of different asset classes in a portfolio. It is no surprise, then, that institutional investors are worrying about the extent to which their ‘diversified’ portfolios are dependent on equity risk, and paying more attention to the diversification that is available within – as well as between – asset classes.
For decades, equity diversification has, for the large part, been considered along the lines of size, sector, and country or region. Increasingly though, investors are coming to believe that different investment styles also offer compelling diversification opportunities.
“Style has become a much more important driver of diversification, and also of returns,” says Richard Dell, a principal at Mercer. “There is an increasing awareness from clients of the importance of having a diversified portfolio by style.”
Traditionally, these investment styles have included value and growth strategies. Now, however, the scope is widening.
“We tend to look at styles that not only have empirical support but also have a strong economic rationale about why they exist,” Dell explains. “Value is a very well-known risk premium. Momentum is also a well-known and academically supported risk factor. Then you have high-quality or high-returning companies. The fourth may be low-beta or low-volatility stocks, which have grown in both acceptances from the academic community and in terms of product development opportunities.”
Style investing was advocated by Eugene Fama and Kenneth French. They observed in the early 1990s that small-cap and value stocks tended to outperform. Academics have subsequently added momentum and low-beta to that grouping.
Like Dell at Mercer, in a recent research paper, ‘Investing with Style’, AQR Capital Management argues that there are four “intuitive” investment strategies which, when applied effectively, produce long-term returns with very little correlation between asset classes and markets. These are value, momentum, carry, and defensive.
Institutional investors are most familiar with value investing, the idea of buying undervalued assets and selling overvalued ones. AQR argues that once an investor has sorted a universe of stocks by some measure of fundamental value to price, like P/E, P/B or P/FCF, they can go long and short within that universe, resulting in a portfolio with very little correlation with the overall market.
Momentum – the tendency of assets to exhibit persistence in their relative performance for some period of time – is also well understood. Again, AQR argues that by going long, the stocks that have outperformed their peers and short the underperformers, the portfolio has little correlation to traditional markets.
Carry is based on investing in higher-yielding markets or assets and financing the position by shorting in lower-yielding markets. “For stocks, the carry earned is the expected dividend yield,” says AQR in its paper. “Thus, in the case of equities, carry is closely related to value, but the two measures are not identical.”
The last investment style AQR identifies – defensive – involves low-beta or low-risk strategies. Here again, a marlet-neutral portfolio can be constructed by applying some leverage to lower-beta stocks to equalise the long portfolio’s beta with that of the short side, while capturing the now widely-accepted fact that lower-beta stocks offer a better long-term risk-adjusted return than higher-beta stocks.
According to AQR’s research, from 1990 to 2012 the four styles provided a tremendous amount of diversification against one another, in addition to a portfolio of traditional assets.
In particular, value and momentum were powerful diversifiers against one another, while still both having long-term positive risk-adjusted returns. However, readers will have noticed the ‘catch’ to style investing as AQR presents it.
“If you want to get diversification away from the market risk premium then you have to do some shorting and use some leverage,” concedes AQR managing director Antti IImanen.
“If you use these styles in a long-only portfolio, then these styles are highly correlated to each other because they move with the equity market, and you end up having portfolios which have lots of the same market direction, and less diversification.”
Readers might also have noticed that neither Dell at Mercer nor AQR mention the size effect.
“The classic styles used in stock selection have been value and size,” Ilmanen observes. “It’s noteworthy that we don’t include size in our report. We don’t think it’s a natural fit. We like styles that make sense across many asset classes, and it’s hard to think about where small-caps would fit in currency or bond markets. Small-caps also tend to be illiquid, and they also tend to coincide to some extent to value.”
Others see the size effect as a key component to style investing.
“We see style allocation, whether it’s value-growth or large-cap-small-cap, as an additional alpha source, next to regional and sector allocations,” says Patrick Moonen, senior strategist, equities, within the strategy and tactical asset allocation team at ING Investment Management. “Managing a portfolio purely on value and growth remains a very rough measure. It’s a bit like doing an eye operation with a butcher’s knife. You classify your whole investment universe in only two groups and you can take some sector and regional risk. So we use it, but as an additional source of alpha. We go long one and short the other.”
ING uses momentum as part of its investment process, both for its global tactical asset allocation strategies, but also within different asset classes. “It’s not an investment methodology as such. It’s not like value or growth, where we make explicit calls for one or the other.”
Natixis Asset Management refers to ‘factors’ when it discusses style investing, and defines them as volatility, momentum, value, and small-caps. Yves Maillot, head of European equities, points out that it is difficult to invest in all of these different strategies.
“It depends what your objectives are,” he says. “For instance, if you have an absolute-return approach then, of course, you can hedge your portfolio by a pure index short, and you can build alpha in the portfolio by long/short strategies. The key thing to remember is that you don’t get regular, consistent performance. If you add all four strategies to the beta you have more chance not to underperform because there is de-correlation between small-cap factors, value factors, momentum factors, and volatility factors.”
Managers say that clients are demonstrating their interest in using the strategies.
According to State Street Global Advisors (SSgA), clients initially come to the firm because they want a fundamental tilt to their portfolio. They then become interested in other things, but are unsure how to combine the different strategies.
“People have said, forget about the cap-weighted index for the time being, let’s think of the different ways and combinations of fundamental indexing, quality, and low volatility,” says CIO Rick Lacaille. “So they’ll set aside CAPM and assemble different building blocks and try to be diversified. We’ve done that for clients who want a completely different take on a portfolio. So they have combined fundamental-weighted indexing, tilted with a quality-weighted portfolio, with a low-volatility portfolio weighted towards the low-risk stocks and towards momentum. So we have been doing work with clients on thinking of combinations of these advance betas.”
For all that managers are doing and offering, however, investors are still deciding how much they want to commit to a style-based strategy, either as a dominant part of portfolio construction, or an additional value-add overlay. “We’ve seen a lot of interest in the products launched which try to measure the different performance of these different styles, and we know that there are investors who consider them in isolation or want to build a portfolio with a diversified style range,” says Simon Midgen, index product specialist at L&G Investment Management. “But, so far, the bulk of the money is being allocated to value. I wonder if it is the case with these other investment styles like volatility, momentum, and quality that it takes time before it feeds through in an investment process.”
At GMO, Anthony Hene, member of the global equities team, makes an important point about diversification along style lines.
“Today, there is an interesting constellation of valuations,” he observes. “US high-quality stocks are particularly attractively positioned. We have them priced as consistently delivering 4%-5% a year. But at the same time, in Europe, it is the value companies that are trading very cheaply. European non-financial value stocks are generating 6%-7% per annum relative to global equities.”
Hene says that, practically speaking, the approach involves taking mean reversion principles to work out what returns are implicit in the investment style.
“Our starting point is that no style has the right to outperform. It’s wonderful to think there is a holy grail out there, but individual styles will only outperform when they are priced to outperform. So it’s all about trying to ascertain which styles are priced to outperform.”