With some factors (or styles) demonstrating strong historic returns, investors have increasingly looked to tap-into their potential. As a result the popularity of products offering access to likes of ‘value’, ‘momentum’ and ‘low volatility’ has boomed.
When considering the merits of various options however, it is important for investors to consider the implications of how factors are identified and accessed.
Mind the overlap
The simplest way to create a factor exposure would be to rank the stocks in an index on a particular characteristic and invest accordingly. For ‘value’ you could select stocks on the basis that they have a lower than average price to earnings ratio.
Doing so may not give the desired results however. Why? Because in reality individual factors are not correlated with other factors. A stock that looks good value may actually be one with poor momentum so investing in it from a ‘value’ perspective is unlikely to result in the anticipated or sought after return characteristics.
True style exposures
Our solution is to refine raw styles with a systematic methodology that aims to remove the overlap between styles. Done effectively and such an approach can result in an improved metric of the desired style. We call the results of our process ‘true styles’ and believe they afford a number of benefits over their raw counterparts:
• Lower correlation between individual factors
• Enhanced long-term returns potential
• Reduced volatility
The line chart shows the ‘true style’ of value companies compared to ‘raw value’ companies, characterised by a high book-to-price ratio.
Source: BMO Global Asset Management, Factset from 31.12.1987 to 31.12.2016. Universe: MSCI World.
Once effectively refined the true style exposures can be applied with a view to achieving a range of outcomes. It may be the outperformance of a market index or in a long/short framework seeking to deliver positive returns independent of market conditions, making it an attractive component for multi asset portfolios.