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After a particularly difficult 2020, 2021 proved favourable for multi-factor equity strategies investing in the cheapest, most profitable and least risky companies with the strongest momentum in each sector.
Fortunately, tough years such as 2020 tend to be rare. The outperformance of the cheapest stocks in 2021 was significant in explaining last year’s good performance of multi-factor strategies, at the global level and in the US and Europe (see Table 1). However, this was not the only factor: Stocks of companies that were profitable, low risk and had strong momentum played their part, albeit to a lesser extent.
Table 1: Simulated 2021 returns of world, Europe and US multi-factor equity strategies
Simulated returns of multi-factor equity strategies with ESG integration (scoring higher than the re-weighted benchmark following the removal of the worst 20% ESG rated companies) and carbon reduction (with 50% lower carbon intensity than the benchmark) and annual tracking error targeting the range 3.5% to 4.5%. Source: BNP Paribas Asset Management, Bloomberg, FactSet, Worldscope, IBES, Exshare-ICE. For illustration purposes only. Past performance is not indicative of future performance.
Our research suggests multi-factor equity strategies that invest in the least volatile (low risk), most profitable (quality) and cheapest stocks (value) from each sector with the strongest prior outperformance (momentum) should have had a good 2021, outperforming their respective market capitalisation benchmarks as performance returned to what is suggested by long-term historical simulations.
This is good news in that it is a sign that the performance of these strategies may be normalising – as we suggested a year ago in Equity factor investing: Putting performance into perspective.
When we investigate the likely contributors to the performance of these strategies in 2021 using the methodology recently detailed in Factor investing: Understanding your performance!, we find that value stocks, which were responsible for most of the pain in 2020, now played a significant role in explaining the outperformance in 2021.
Quality stocks also contributed to outperformance in 2021, although not by as much as value stocks and less in Europe, where momentum and low volatility stocks more likely played major roles in explaining good performance.
Exceptions that confirm the rule?
2020’s travails led many multi-factor equity managers to question the extent to which investing in the less risky, most profitable, cheapest and strongest momentum stocks could beat market capitalisation benchmarks in the future.
As said a year ago, 2020 was not the first time multi-factor equity strategies did poorly. The tech bubble of 1998-99 and the Global Financial Crisis of 2008-09 were other difficult periods. To a great extent, 2020 resembled the tech bubble of the late 1990s, when value stocks underperformed, accompanied by a widening gap between their valuations and those of the most expensive stocks.
Both in 2020 and in the late 1990s, value stocks became progressively cheaper, while the most expensive stocks became even dearer. As we showed in when value spreads compress, the widening gap between the valuations of the cheapest stocks and those of the most expensive stocks leads almost inevitably to underperformance of the cheapest stocks.
But when the gap becomes extreme – as happened in late 1999 and late 2020 – outperformance of the cheapest stocks in the following years is extremely likely as the gap shrinks back to long-term trend levels. Despite the good performance of value stocks in 2021, the gap remains too wide. We will explore this in a future publication.
ESG integration and carbon reduction
Given that companies with higher environmental, social and governance ratings tend to be less risky and more profitable than their peers, ESG integration blends in naturally with strategies that aim to invest in stocks with exactly those features: Less risky and more profitable.
In conclusion, the current environment looks favourable for strategies that invest in the cheapest of the less risky and most profitable stocks, such as multi-factor strategies, in particular when portfolio optimisation is used for portfolio construction. This makes it easier to satisfy any ESG constraints needed to meet sustainable investment regulations.
This is good news for sustainable investors seeking equity strategies with ESG integration and carbon reduction and that can outperform benchmark market capitalisation indices.