Factor investing is an investment approach that involves targeting quantifiable characteristics or “factors” that can explain differences in security returns. A factor-based investment strategy involves tilting portfolios towards and away from specific factors in an attempt to generate long term investment returns in excess of the market.
The approach is quantitative and based on observable data, such as security prices and financial information, rather than on opinion or speculation. Factors are simply a set of properties common to a broad set of securities. As outlined in the book ‘Your Complete Guide to Factor-Based Investing’, Andrew Berkin and Larry Swedroe note that to be worthy of exposure, a factor must be:
• Persistent – it works across long periods of time and different economic regimes;
• Pervasive – it works across countries, regions, sectors, and even asset classes;
• Robust – it works for various definitions of the factor;
• Investable – it works not just on paper, but also after considering implementation issues like trading costs;
• Intuitive – there are logical risk-based or behavioural-based explanations for its premium and why it should continue to exist.
Some of the most commonly observed factors are:
• Value – securities with lower prices relative to their fundamental value;
• Size – securities with lower market capitalisation;
• Momentum – securities that have outperformed in recent time periods;
• Minimum Volatility – securities that demonstrate lower volatility;
• Quality – securities that demonstrate higher profitability and resilience.
Following sustained inflation around the world, and subsequent rapid rate hikes from the Bank of England and other central banks, fears are growing in the UK regarding a potential recession. On 23rd August the UK Purchasing Managers Index (PMI) figures, a measure of the health of the economy, came in at 47.9 for the month, down from 50.8 in July and below the neutral 50 mark for the first time since the start of 2023. Following this, data published by the Office for National Statistics on 13th September indicated that UK GDP had fallen by 0.5% between June and July, with a further slowdown across a wide range of sectors expected for the months ahead.
Different factors provide relative outperformance vs the market at different points in time, and at different points in the economic cycle. While the evidence suggests that it isn’t possible to identify economic cycles and resulting factor performance in advance, it should be noted that historically there have been a number of factors that have typically outperformed in recessionary environments.
The two that we believe are worth noting specifically are:
Minimum Volatility – through its focus on securities with lower volatility compared to their peers, the Minimum Volatility factor is inherently defensive in nature and can outperform in recessionary environments, compared to the wider market. The idea that Minimum Volatility securities have a premium is counterintuitive to conventional investment thinking, which suggests higher rewards are inextricably linked with higher risk. However, there are various potential rationales behind why the Minimum Volatility factor premium exists, including:
• Skewness preference – many investors prefer the lottery-like payoffs of high volatility stocks, which have the possibility of large returns. This can lead to a premium for higher volatility securities that is not warranted by fundamentals;
• Behavioural biases – investors can be over-confident and overpay for attention-grabbing stocks. This leads to increased media coverage, which tends to increase volatility, generating demand that leads to further overvaluation.
Quality – through its focus on profitability and resilience, the Quality factor can also provide a defensive role in a portfolio, and outperform in recessionary environments. This is due to its focus on profitable companies, with higher returns on equity and consistent profitability over time – such firms are inherently more resilient in an economic slowdown. It also emphasises companies with lower leverage, which leads to increased resilience to a downturn in economic conditions. Again, there are a number of potential rationales behind why Quality can add value compared to the broad market.
These include:
• Risk-based – profitable firms experience various dynamics, including attracting greater competition (due to the potential for greater profits), which increases uncertainty and requires a risk-premium;
• Behavioural biases – investors expect prices of profitable firms to mean-revert faster than they actually do, which can lead to premature selling. Or put another way, it can be psychologically preferable to back the revival of unprofitable firms, than to expect continued strength in profitable firms.
In summary, there are a range of commonly observed factors in the market, each of which can provide outperformance compared to the market at different points in time. Minimum Volatility and Quality are two factors that have historically provided outperformance in recessionary-type environments. However, rather than trying to time the market, the evidence suggests a diversified factor-based approach (in which exposure is gained to a basket of observed factors) is a more optimal approach than focusing tactically on a small number of factors.
Blog Post by Jonathan Griffiths, CFA
Investment Product Manager at ebi Portfolios
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