Factor-investing has not been the same since the global financial crisis (GFC), a new analysis by index provider FTSE Russell shows, as the flight to low-volatility and quality stocks intensified.
According to the FTSE Russell study published last week, low-volatility and quality shares generated the highest returns with the least risk compared to the four other factors analysed over June 2008 to October last year.
However, during the 16-year period ending last October low volatility and quality underperformed all other factors bar momentum – albeit while retaining their lower risk attributes.
“The GFC increased investor interest in downside protection: Low Volatility and Quality outperformed Value and Momentum between June 2008 and October 2017,” the FTSE Russell report says. “Size performed in line with the defensive factors, but with significantly higher levels of volatility. Value was the real laggard, with a negative active return and a 12.3% increase in risk relative to the FTSE All-World Index.”
Defensive low volatility and quality stocks outperformed the index during all sustained “periods of market contraction” since December 2001, the study found, while momentum, value and yield factors produced sub-benchmark returns.
Size (a factor targeting the historically higher returns on offer from smaller companies) was constant through all business cycles, the report says.
“The volatility of all factor index returns is substantially higher during periods of contraction,” FTSE Russell says.
Given the fluctuating fortunes of factors over time the report says institutional investors may benefit from combining the strategies into asset allocations based on risk preferences.
For example, FTSE Russell found significant risk-and-return differences across three mixed factor portfolios it back-tested: defensive (low volatility and quality); diversified (low volatility, quality, value and size); and, dynamic (value, size and momentum).
“Factor investment strategies can help to achieve several investment objectives: enhance risk-adjusted returns, reduce portfolio volatility and enhance diversification,” the report says.
The approach, a half-way house between active and passive investment also known as smart beta, has caught on with many institutional investors including the NZ Superannuation Fund (NZS) which awarded Northern Trust two $300 million factor mandates in 2016 targeting low volatility and value.
However, the FTSE Russell report says investors need to carefully assess their beliefs around the longevity and strength of factors they wish to gain exposure to.
For instance, momentum (a ‘trend is your friend’ philosophy) may dissipate quickly while size is a “highly stable factor”.
“The defensive factors Quality, Yield and Low Volatility have a long life span, but their intensity is low relative to the dynamic factors such as Value and, in particular, Size,” the study says.
Factor investors must also monitor portfolios closely to attribute the real sources of return.
“No one has ever seen a bad back-test,” FTSE Russell says. “It is important to examine the live track record of a factor index and review its sources of performance. It is critical to ensure that performance sources are consistent with an index’s espoused objectives and not the fortuitous result of reward from accidental off-target factor exposures.”
FTSE Russell favours a bottom-up approach to combining factors rather than the top-down method that creates single factor portfolios before mixing.
“Conversely, a bottom-up approach applies an integrated approach to delivering portfolio factor exposure in a single step,” the study says.