Once a niche strategy, factor investing has transformed portfolios since the financial crisis, says Bruno Taillardat of Amundi.
The financial crisis of 2008, and to a greater extent the Sovereign debt crisis, popularised low-volatility or minimum variance strategies as solutions to resist market crashes.
Now, factor-based investing has been established in asset management to such a degree that it is a well-recognised tool. “Factor investing is not just a product”, states Bruno Taillardat, Global Head of Smart Beta and Factor Investing at Amundi. “It has transformed the way in which portfolios are built.”
Momentum, size, value, low volatility or quality; it is important to understand the style factors exhibited by funds because they influence behavior in different market conditions. Typically, we can split equity factors into two broad groups: those with defensive characteristics and those with cyclical attributes.
Taillardat adds: “Momentum navigates between them, depending on the market context.” Like low volatility, the “quality” factor tends to perform well when the economy is contracting. They are defensive attributes. The “quality” factor emphasises those companies with lower debt and higher profit margins rather than the market average.
Most importantly, these firms are capable of comfortably generating regular cash flows. They provide a measure of protection during a period of rising interest rates because they have few liabilities on their balance sheet.
During a bull phase of the market, the “value” and “size” factors are generally more successful. The “value” factor is rather risky, as it groups stocks that have a low valuation and thus neglected by investors. By definition, these offer the potential for a considerable value increase, particularly during economic expansion when inflation and rates increase, encouraging investors to take more risks. The “size” factor is also relatively risky, focusing on small and mid-cap stocks and the liquidity risk premium they offer. These companies benefit from a positive environment and can be impacted by stagnant conditions. On its own, the “momentum” strategy can be an asset when included within a long cycle. It focuses on stocks that are performing strongly and rely on the economic trend continuing. If market cycles reverse, momentum can suffer.
“Factors provide another way to monitor portfolio risk. Furthermore, it is important to see if the alpha generated by a strategy relates not only to its benchmark index, but to a specific factor as well,” adds Taillardat.
Using factors to drive performance
It is important to understand how factors drive a portfolio or a fund. Taillardat cites:
1. Sectoral composition. Within each factor, there are structural sector exposures. The Consumer Staples sector tends to feature Low Vol and Quality, while the financial sector is associated with Value. But sector exposure can change. Low Vol, for instance, is currently relatively exposed to Financials.
2. Macro drivers. Elements such as the macroeconomic environment also influence these factors. Low volatility tends to perform better in moments of low rates, and when rates are declining, as companies that exhibit this factor tend to be seen as bond proxies. Value, on the other hand, tends to do very well in strong rally periods in the stock market.
Knowing this, you might be tempted to shift your portfolio towards one factor or another based on market conditions. Taillardat cautions against this because, as with market timing, it is very hard to determine the exact moment to move from one to another. “When you have little information on the future, the best response is usually to diversify,” he says.
Maintain diversification, he adds, since the performance of these factors is so cyclical that it varies year by year.
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Investing carries a risk of loss of capital. Promotional and non-contractual information. Accuracy, completeness and relevance of information not guaranteed. Information prepared from sources considered reliable as of December 2019. This document may contain information from third parties, provided for information purposes only, does not constitute an implicit or explicit approval by Amundi. Index providers do not make any declaration as to the suitability of any investment. This document is not intended to any “U.S. Person”, as defined under the U.S. Securities Act of 1933 and provided on www.amundi.com.
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