Multi-factor equity investing has underperformed in 2020 as a small number of growth stocks left the peleton far behind. Daniel Morris (DM), chief market strategist, and Raul Leote de Carvalho (RLC), deputy head of the quantitative research group, discuss the outlook for multi-factor equity portfolios.
The performance of factor investing in equities has disappointed. Is the approach still valid?
RLC: We are well aware of the reports of dissatisfaction among some investors regarding the performance of multi-factor equity portfolios in 2020, but we have no doubt that the strategy remains viable.
Typically, quantitative equity strateies rely on combining the five following factors in multi-factor equity investing: quality, momentum, low risk, value and size.
- Quality (Buy stocks from the most profitable companies), has generated exceptionally good performance in 2020
- Momentum (Buy stocks that have been out-performing), has also done well this year
- Low risk (buy stocks of lower-risk companies), has had varied performance by region in 2020.
The source of underperformance this year is clear: the two culprits are:
- Value (Buy the cheaper stocks), underperformed significantly everywhere. To be clear: The underperformance of multi-factor equity strategies in 2020 has been more or less entirely a function of a bad year for value
- Size (buy stocks of smaller capitalisation companies), has underperformed as a small number of mainly mega-cap tech stocks outpaced the rest of the market. Some multi-factor equity strategies have a tilt toward small caps. This hurt in 2020.
Exhibit 1: Underperformance of multi-factor strategies in 2020 is principally due to a bad year for value
Source: BNP Paribas Asset Management, as of 31/10/2020
In our new research paper, we find that in global markets, the US and Europe, only value and size underperformed. Quality did extremely well across all regions, as did momentum. The performance of low risk varies by region, but previously it was good across all.
This is not the first time we have seen an underperformance of value. Value lagged significantly during the run-up to the dotcom equity bubble in 1998/2000. It then recovered. This year, the underperformance of value has been particularly severe. Our research suggests no factor has previously underperformed to the extent value has this year. However, since early November, we have seen something of a correction with value outperforming growth. It remains to be seen if this is temporary or a change in the trend.
Exhibit 2: The extent to which value has underperformed in 2020 is without precedent
Source: BNP Paribas Asset Management, as of 31/10/2020
Our value factor has done poorly since mid-2018. We do not employ the size factor because we invest in a universe of mid- to large-cap stocks. Recently, however, we have witnessed strong performance of large-cap relative to mid-cap stocks, which is further bad news for managers who employ the size factor.
How do you explain the significant dispersion in performance?
RLC: In my view, inadequate factor diversification is the best explanation. Some managers tend to over rely on value and/or inadvertently create exposure to size.
Dispersion of performance is not just a question of diversification. Performance of a multi-factor strategy depends on the choices that go into building exposures. When I say that our value strategy has only underperformed since mid-2018 that reflects the choices, we have made with regard to how we implement the value strategy in portfolios.
In Equity Factor Investing: Historical Perspective of Recent Performance, we show that conventional choices are likely to lead to poor results. In particular, we use a selection of factors in each style, with selection based on their diversification. We neutralise sectors. This means that if an entire sector looks cheap, the value factor cannot be filled with companies from that group because they are risk factors to which we do not want to be exposed. We also control for the beta, or sensitivity to the market. Finally, we manage the risk in the portfolios.
We demonstrate in our research that all these choices significantly enhance the risk-adjusted returns. As far as the value factor is concerned, more standard choices would have resulted in longer and more severe underperformance.
What else might explain the dispersion?
RLC: Everything I have discussed so far ignores the impact of possible constraints on portfolio construction. That is to say, my analysis has been based purely on the academic exercise of judging to what extent the information content of factors, as we employ them, has been predictive of stock returns. We look separately at the impact of portfolio constraints on performance in a real world context.
Most equity multifactor funds use the factor information content along with an algorithm to construct portfolios and impose common constraints. For example, they use the factors to build long-only co-mingled funds, with the assets fully invested in stocks and no short selling of stocks allowed.
In our research paper we have shown that most managers, in particular those implementing these strategies in global and US equity portfolios, may have suffered from not being allowed to hold outright short positions in stocks.
Moreover, the fact that in 2020 a very small number of large-cap tech stocks has significantly outperformed, means these stocks now account for the lion’s share of the S&P 500 and MSCI World indices.
We have historically high levels of concentration in market-cap indices. Under these circumstances, multi-factor equity managers had little choice but to underweighted the largest capitalisation stocks in those indices to fund other stock purchases proposed by their models, even if their models did not specifically advocate selling those large-cap stocks. The concentration of the benchmark meant there was really very little choice in the stocks that could be underweighted.
Unfortunately, this has been costly because those largest cap stocks very significantly outperformed.
What do you think happens next? Does ‘value’ recover?
RLC: Firstly, it depends what we mean by value. If we look at a simple MSCI value index then we would see underperformance since 2007. We believe investors have to control for exposures non-related to value such as particular sector exposures, which we neutralise.
On this basis value performed well until mid-2018. I would stress again that this is not the first time value has underperformed.
All strategies go through difficult periods. I have already mentioned the dotcom bubble but the period immediately after the Great Financial Crisis of 2008 was also difficult. Today, just as in previous periods of underperformance, Value factors are at extreme levels of underperformance, and the dispersion of valuations between cheap and expensive stocks is again at similar extreme levels.
Timing is difficult. Our approach is to stay invested all the time, but if we were not invested we would tend to think now is a good time to invest. We would expect to see a normalisation of the performance of these strategies soon, if it is not already underway.
You can find the paper written by Raul and the quantitative research group “Equity Factor Investing: Historical Perspective of Recent Performance” here.
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