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Factors Introduction; Quality and Minimum Volatility
Securities with lower prices relative to their fundamental value
Securities with lower market capitalisation
Securities that have outperformed in recent time periods
Securities that demonstrate lower volatility
Securities that demonstrate higher profitability and resilience
Despite the Bank of England’s forecasts of flat growth over 2024, an increasing number of analysts are predicting that the UK will tip into recession over the coming months, compounded by the expectation that UK monetary policy will remain tight for some time.
Turning our attention back to factors, we can observe that different factors provide relative outperformance compared to the market at different points in time, and at different points in the economic cycle. While it is extremely difficult, if not impossible, to consistently identify economic cycles and resulting factor performance in advance (with timing being one of the most challenging aspects), historically Quality and Minimum Volatility have typically provided stronger returns in recessionary-type environments. We’ll now explore these two factors in turn.
Quality – The Quality factor focuses on profitable companies, with high returns on equity and consistent profitability over time. Through this focus on resilience and profitability the Quality factor can provide a defensive role in a portfolio, a characteristic in favour during recessionary environments – with firms demonstrating high returns on equity and consistent profitability over time being inherently more resilient in an economic slowdown. The Quality factor also emphasises companies with lower leverage, which again leads to increased resilience to a downturn in economic conditions.
There are a number of potential explanations2 behind why the Quality factor can add value compared to the broad market. These include risk-based explanations, which are founded on excess risk-adjusted returns being achievable due to investors undertaking financial risks, and behavioural-based explanations, which are founded on investor psychology and expectations.
Risk-based explanations for the Quality factor include the concept that profitable firms experience various dynamics, that require a risk-premium to be placed on them by investors. For example, profitable firms may attract greater competition due to the potential for greater profits by new market entrants. This increases uncertainty, leading to investors placing a risk-premium on such firms.
Behavioural-based explanations for the Quality factor include the idea that investors may expect that the prices of profitable firms to mean-revert faster than they actually do, which can lead to premature selling. Stated another way, investors might find it psychologically preferable to back the revival of unprofitable firms, than to expect continued strength in profitable firms.
Minimum Volatility – the Minimum Volatility factor focuses on securities with lower volatility compared to their peers. Through this prioritisation of less volatile securities, the Minimum Volatility factor is inherently defensive in nature and can outperform in recessionary environments, compared to the wider market.
However, risk-based explanations for the Minimum Volatility factor break down, as 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.
This leaves us with behavioural-based explanations3 for the factor. For example, we frequently see investors display signs of over-confidence, which can lead to sub-optimal investing, such as the over-paying for attention-grabbing (volatile) securities. Alongside this, we may see such securities generate significant media coverage, leading to increased volatility, and generating demand that leads to further overvaluation. Additionally, we see investor characteristics such as skewness preference, with investors preferring the lottery-like payoffs of high volatility securities, which have the possibility of large returns. This can lead to a premium for higher volatility securities that is not warranted by fundamentals.
In summary, factor investing is an investment approach that involves targeting quantifiable factors that can explain differences in security returns, tilting a portfolio towards or away from these factors in order to generate additional return or reduced risk. Quality and Minimum Volatility are two of the five most widely accepted factors, with their focus on profitable and resilient companies, and lower volatility securities, respectively. These two factors have typically performed well in economic downturns, and they play a core role as part of a diversified factor-based portfolio.
In the next article in the series, we’ll go on to explore other factors in the factor investing toolkit, and how these can add value as part of a diversified factor-based approach.
Blog Post by Jonathan Griffiths, CFA
Investment Product Manager at ebi Portfolios