Treasury Today Country Profiles in association with Citi

Factor investing: rising above cap-weighted benchmarks (part one)

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Factor investing offers scope for more precise portfolio construction. In low return environments, are they a more effective means with which to assess market risk and enhance returns? In part one we look at what it is and why it might be used.

Treasurers frustrated by the low-yield investment environment rarely consider equities for surplus assets being held, simply because equities tend to be at the higher end of the risk spectrum. But when considered along ‘factor investment’ lines, they can present risk returns that even pension and insurance firms find acceptable. For Dean Heaney, Institutional Sales Director at Invesco, there is scope for treasurers to explore and benefit from Factor Investing, should they wish to allocate to equities.

Traditional ‘style box’ portfolio investing in equity markets, where an investor might pair equally weighted stock characteristics such as growth and value, tends to lack diversification. It also offers limited opportunity for relative outperformance of a market capitalisation-weighted equity indices, such as the S&P 500 or FTSE 100.

Sitting somewhere between active and passive fund management, factor investing creates a portfolio based on a wide range of ‘risk premium’ factors. Whilst specific risk factor possibilities range in the hundreds, there are six that have been assessed by academics and industry experts as likely to produce the most rewarding outcome across market cycles and geographies when blended within a portfolio.

The key factors according to Invesco are:

  • Value:

    Examining a stock’s earnings, book value and sales relative to its price. The higher these fundamental ratios are, the cheaper the stock.

  • Small size:

    Ranking stocks by their market cap, with smaller companies ranking higher, earning the investor a premium.

  • Low volatility:

    Considering the magnitude of rise and fall of a stock’s trailing 12-month price returns.

  • Momentum:

    Stocks that have had high risk-adjusted 12-month returns, excluding the most recent month.

  • Quality:

    Companies with fundamental ratios that point toward a strong balance sheet and stable earnings growth.

  • Dividend yield:

    Ranks stocks based on their annualised dividend yield.

The aim

An academic understanding of factors in investing dates to the 1960s. With access to more powerful data analytics, driven by advances in research into investor behaviour, the level of insight available for fund managers today means more sophisticated factor-based strategies are now possible.

The investment aim is to build a portfolio by selecting stocks that err toward the chosen factors. With each factor typically performing differently based on macroeconomic influences, investors can deploy them within a portfolio to try to achieve a desired outcome, based on their own market outlook. By targeting these underlying drivers of return, a more finely tuned, systematic approach to portfolio construction is achieved.

“Looked at over time, multi-factor portfolios consistently beat a market cap weighted equity index for investor returns,” says Heaney. “By blending a number of different factors, investors can achieve a better outcome.” The firm’s Global Multi Factor Equity portfolio, for example, over 18 years, has delivered an excess return above its market cap weighted benchmark of over 1.25% year-on-year”.

Next week we look at build, purpose and possibilities for treasurers.