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Framing Factors

15 June 2020

Factor investing offers a huge opportunity set for equity investors, but deterministic models based on the past make it hard to harness. GAM Investments’ Julian Howard suggests a more holistic approach might make more sense.

In the 1999 movie The Matrix, protagonist Neo played by Keanu Reeves, has an epiphany moment where the world around him becomes a series of digital 0s and 1s and he sees for the first time how it is really constructed. This is also a good way to understand investment Factors. The equity market and what drives its returns were traditionally viewed in terms of country, sector or stock performance. But in 1992 academics Fama & French highlighted a less visible, but equally powerful, way to explain investment performance and therefore a potential new route to outperformance. While nearly 300 Factors have been identified today, seven of them remain more commonly discussed by investors, specifically: Size (small cap stocks), Value (cheap stocks), Yield (high dividend stocks), Momentum (stocks that have done well), Low Volatility (defensive stocks), Growth (stocks with strong earnings growth) and Quality (stocks with steady revenue streams). These seven Factors alone represent a massive opportunity set: from end June 1995 to 18 May 2020, there was a 144% point difference between the best performing factor (Quality) and the worst (Value) relative to the S&P 500; see Chart 1. Yet Factor investing has not gained widespread traction as investors have struggled to identify in advance which Factors do well relative to the others. Today, with equity markets now facing a deep economic slump it is worth reviewing the evidence to assess whether active Factor investing – emphasising or avoiding discrete Factors – now merits reconsideration. While full justice cannot be done to the subject in the space of a single article, we highlight some key areas which investors can use to aid their understanding of the issues and inform their decision-making process.

Chart 1: Factor opportunity set massive – in theory:

Source: Bloomberg. Past performance is not an indicator of future performance and current or future trends.

On first assessment, the case for active Factor investing does not look universally compelling. One of the very first Factors which Fama & French identified – Value – has performed poorly since the early 1990s despite exhibiting strong outperformance across many periods before that. Investment legends such as Benjamin Graham come to mind as proponents of Value investing, making their names in holding overlooked stocks and patiently waiting to be rewarded when the market inevitably reassesses them. So why has the style failed so completely in the last generation? We believe a strong contributor has been economic stagnation. For cheap stocks to perform well they generally require accelerating economic growth reflected in steepening yield curves after a period of economic upset. While Value stocks did have a brief resurgence in 2009, they rapidly faded afterwards despite the basic ingredients for their outperformance being in place; see Chart 2. This was because economic growth went sideways following the financial crisis after only a tepid recovery. Crudely speaking, the last decade has seen the US rate of GDP growth settle around 3%, the UK around 2% and the eurozone around 1%. A combination of headwinds have kept growth down, including but not limited to ageing demographics, slower innovation, poor productivity, and inequality. The coronavirus pandemic is only likely to worsen these challenges as immigration slows, economies turn inward, companies delay investment and opportunities shrink. As such, Value as a style may stay out of favour for an extended period despite long running academic evidence pointing to it as a potential source of outperformance. This teaches us less to ditch Factors altogether than to discriminate all the more carefully between them. While Value has foundered, Growth has ironically performed well during the last decade of low growth and may well continue to do so. This is because Growth stocks are best thought of as long duration assets with a demonstrated ability to generate profits which investors extrapolate into the future. The low discount rates that characterise the policy response to stagnation are perfect conditions for price appreciation, as the present values of Growth stocks’ future earnings streams are discounted at effectively zero.

Chart 2: Value Factor trapped by economic stagnation:

Source: Bloomberg. Past performance is not an indicator of future performance and current or future trends.

Recent crises and the associated policy response of creating free liquidity have therefore distorted traditional models of Factor out- and underperformance. These models dictated that in an expansion Size, Momentum and Growth should do well, that in a slowdown Quality, Low Volatility and Yield should do well and that in a recovery Size and Value should thrive. Intuitive enough, but as we have seen, structural changes to the economic landscape have made Factor investing hard to apply based on history and may also explain why it has failed to gain widespread acceptance among investors.

Many strategies claiming to be able to generate Factor-based outperformance have struggled in recent years. Emphasising Value has presented an oft-repeated trap. Today the airlines, banks and carmakers that make up a large portion of many Value indices appear cheap, but their business models are now fundamentally threatened by secular change. Similarly, while Quality has been a consistent outperformer, secular shifts may yet threaten it. Quality indices tend to contain many of the packaged goods companies that have exhibited stable revenues in the past, hence the ‘Nestle model’ phenomenon. But these businesses are increasingly finding themselves vulnerable to start-ups using e-commerce platforms to promote new products directly to consumers with far lower marketing and branding costs.  We believe this could be problematic in the coming years, undoing the reputation Quality has for steady growth across all conditions. Yet the algorithmic models and the long-run academic studies of Factor investing are failing to account for this kind of narrative-based secular threat in their assessments. 

A more evolved approach to Factor investing might therefore integrate both better modelling with a fundamental overlay to ensure a given Factor signal actually makes sense before it is invested. For example, enhanced models assessing Value might look beyond the mere cheapness that appeared to guarantee success up to the early 1990s. Instead, more sophisticated long-run economic expectations, measures of productivity and perhaps even gauges of inequality should be included. Quality models for their part might now assess firms’ revenue streams from developing markets where e-commerce can cause more rapid and profound disruption than in regions where middle class consumer habits are long-established. This way, potentially vulnerable businesses can be excluded. Then, a fundamental overlay could be applied to sense-check the models’ output and potentially develop a meaningful narrative. The road to better Factor investing will include a steep learning curve. But this year to 18 May alone the relative performance dispersion between the best and worst Factors versus the S&P 500 was a massive 22.4%. In our view, therefore, the rewards continue to be potentially significant and an innovative approach to Factor investing could well unlock superior performance.

Important legal information
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of the manager in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development. June 2020.