Erik Rubingh, head of systematic strategies at BMO Global Asset Management, discusses the benefits of style-based investing and its potential application for absolute returns.
HISTORY
Traditionally, people would look at equity fund performance to see how much of the returns came from the market, beta, and how much came from manager skill, alpha. With the passing of time and additional insights from academia, a lot of what has historically been labelled as alpha can be attributed to taking exposure to specific styles or factors.
HOW DO STYLES WORK?
There are various recognised styles such as value, quality and momentum. You can get exposures to these factors in long-only equity products, either through a simple smart beta product (e.g. an exchange-traded fund which has exposure to defined factors) or through a more advanced approach in which the style exposures are more refined.
Either way, most of the total risk will still be coming from the equity market. Style investing, however, can also be done in a way that aims to counter equity risk with a view to generating absolute returns from styles, irrespective of the performance of the underlying asset class.
One question, of course, is that if we can take exposures to widely recognised styles, is it reasonable to expect positive returns to persist? There are two schools of thought supporting the long-term potential of defined factors/styles. Firstly, the efficient market explanation (Fama and French, 1992) is that taking exposure to factors is risky and you should be compensated for taking these risks, just like in the long term, one should be compensated for holding equities.
The second relates to behavioural finance. Efficient market proponents make out that people are efficient and emotionless investing machines. However, ample empirical evidence suggests that this is not the case. Furthermore, it is not just retail investors that are subject to these behavioural biases, and professional investors are making the same type of mistakes. Since human behaviour results from tens of thousands of years of evolution, we can reasonably expect this to continue in the future.
Whether the returns from styles are due to compensation for risk or a behavioural effect (or some of both), we believe that you can reasonably expect style-related returns to persist.
DIFFERENT STYLES, DIFFERENT RETURNS
Investment styles rarely exist independently of each other. For instance, value and momentum: if the price of the stock goes down, it makes it a bad momentum stock, and even if value goes up, it doesn’t necessarily make it a good investment opportunity. Therefore a simplistic approach fails to recognise that styles are not wholly uncorrelated.
This means that when they are combined, there is a degree of overlap in their return characteristics. This in turn reduces diversification benefits and saps performance potential.
We developed our ‘True Styles’ methodology in order to better isolate individual styles – an approach that leads to better risk-adjusted returns for the styles and much lower correlation between the styles – giving better diversification benefits.
APPLICATION
Style investing works well in long-only equity funds but also in market-neutral equity strategies. The mechanics are the same but instead of going overweight/underweight versus the benchmark, going long and short can create a portfolio that can generate positive returns regardless of market conditions.
Views and opinions expressed by individual authors do not necessarily represent those of BMO Global Asset Management.
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