A factor spring: How factor investing is proving its worth

Northern Trust Asset Management’s Abhishek Gupta explains what the ‘factor spring’ is and why it may be set to continue.

Last year was the second consecutive year of strong equity factor performance. With value, dividend yield, quality, low volatility and momentum outperforming their benchmarks across many global indices, the longest factor winter on record has ended, and there has been a resurgence of factor investing strategies.

Factor investing strategies have enjoyed a period of strong performance over the past couple of years. Coming off the back of a significantly weak few years, it feels like spring has sprung for factor strategies.

For example, global dividend and low volatility stocks outperformed by more than five percentage points in 2022, demonstrating the defence the factor strategies can provide.

“Spring is coming for factor investing after a period that was challenging for strategies given the market was led by growth stocks,” says Abhishek Gupta, senior quantitative strategist at Northern Trust Asset Management.

Green shoots

This recent outperformance has come despite – and, Gupta argues, partly because of – the macroeconomic environment. Geopolitical tensions, rising inflation, slowing economic growth and interest rates have all helped drive investors’ interest in factor strategies.

Global economic growth is expected to be weaker this year than in the past few years, Gupta says, and while central banks may be able to reduce the impact of inflation, it is still expected to remain elevated for the foreseeable future.

“In that context, our analysis over a number of economic cycles shows that it’s really this period of slowing economic growth, persistent inflation, and higher interest rates in which factors such as quality, low volatility, and dividend yield usually deliver their best performance. We see these factors doing well going forward through 2023,” Gupta says.

The volatility and uncertainty at a macro level are pushing investors to look more carefully at company fundamentals, he continues, with green shoots of opportunity potentially emerging in stocks that are relatively less risky, with good cashflows and demonstrating profitability, or that can support long-term dividend payments.

Spring showers

Like always, however, the spring season comes with showers, and there are still some areas that investors must monitor carefully.

Chief among these is inflation. While central banks are raising interest rates to combat the rising cost of living, the longer inflation remains elevated, the more likely it is to impact on corporate earnings. As Gupta explains, this means that “the uncertainty hasn’t really gone away”.

“Our analysis shows that it’s this period of slowing economic growth, persistent inflation and higher interest rates in which factors such as quality, low volatility and dividend yield usually deliver their best performance.”

“We think that there could be a lot of volatility coming through in equity markets, especially from areas such as sector performance, country performance, and currency performance.”

He explains that there was a high level of dispersion between the best- and worst-performing sectors in 2022, meaning that taking strong sector bets “can be a source of significant volatility in your portfolio”.

This makes it particularly important for investors to focus on portfolio construction to ensure an adequate level of diversification and risk management. A “risk-efficient” approach to factor investing can help investors benefit from the factor spring while also preparing them for more wintry conditions in the future.

An all-weather approach

When building a factor portfolio, it is important first to understand how factors are defined – and this can vary from provider to provider. There are different dimensions to the measurement of a company’s quality, for example. As Gupta explains, combining assessments of profitability, cashflows, and management efficiency, gives investors “a multi-dimensional view that allows you to capture quality holistically”.

“It’s also important that you are comparing apples with apples,” he continues. “When you look at financial metrics, comparing an IT company with a financial services company does not make sense because the business models are very different.”

Similarly, when constructing a factor portfolio, it is important to understand how different factors complement each other. When creating a dividend yield portfolio, he adds, quality can provide a view of a company’s fundamentals and identify constituents that have the profitability and cashflows to sustain payouts.

In addition, the portfolio should pick stocks from all sectors and regions to maximise diversification and control for biases and risks.

Gupta explains: “Dividend yield stocks tend to come from companies that are in mature parts of economies – energy, utilities, industrials. Low-volatility stocks tend to be in sectors such as utilities, consumer staples, and healthcare.

“We think there is a potential for this ‘factor spring’ to turn into a ‘factor summer’. With a bit of prudent portfolio construction, we can harness the power of factors and make the most of the difficult macroeconomic conditions we face in 2023 and beyond.”

“If you are naively building a portfolio, you may find you have significant exposure to specific sectors or companies. This can be a source of significant idiosyncratic and macro risk, as you may be taking significant overweight positions relative to the benchmark. These risks can then combine to contribute a lot of volatility to your portfolio while eroding returns.”

As well as ‘traditional’ factors, an important additional one for FlexShares’ funds is sustainability, with environmental, social and governance (ESG) considerations embedded in strategies.

“Sustainability is integral to what we do,” Gupta explains. “We believe that ESG risks such as climate change need to be mitigated. We have integrated both historically aware and forward-looking approaches to sustainability to manage risks associated with ESG issues.”

FlexShares’ funds aim to have a significantly lower carbon footprint than cap-weighted indices – as much as a 50% reduction in emissions relative to the parent benchmark, Gupta says. This approach gives investors direct exposure to companies managing ESG risks better than their peers, and taking advantage of opportunities arising from the transition to a low-carbon economy.

Investing through the seasons

The resurgence of factor investing demonstrates the importance of a long-term view and an awareness of the cyclicality of investment styles.

As Gupta explains: “There is a cyclicality associated with these factors. There are periods that are favourable for factors, and there are periods that are unfavourable. “

“Over the past two or three decades, looking at empirical data, we see that generally, for factors such as dividend yield and value, periods of outperformance can last five to seven years.

“We think there is a potential for this ‘factor spring’ to turn into a ‘factor summer’. With a bit of prudent portfolio construction, we can harness the power of factors and make the most of the difficult macroeconomic conditions we face in 2023 and beyond.

© 2023 funds europe

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