BlackRock’s Manuela Sperandeo explains how factor investing can be used to pursue outperformance in different market environments.
Tilting US portfolios towards value equities and away from minimum volatility is the way ‘smart beta’ investors would have made money over the last quarter. Minimum volatility funds have seen redemptions, and the direction of the US economy has paved the way for the value factor to return to prominence.
BlackRock’s Factor-Based Strategies Group says the reason for this ‘factor tilt’ can be found by looking at some key predictors that may contribute toward forward-looking performance of individual factors. The business cycle, for example, which in the US is in a recovery phase, is an environment that tends to favour value at the expense of minimum volatility stocks. The latter tend to thrive more when sentiment is down.
Factor-tilters are a type of investor that Manuela Sperandeo, head of iShares EMEA specialist sales, expects to see emerge more and more as a type of active investor. Investors are familiar enough with non-cap weighted indices and the factors these indices tap into, to translate their investment views into action, she says.
“I think we are at a turning point where investors are more fluent with factors – and the conversation about how to translate investment views into single factors is going to be a game-changer.”
In a Q&A, Sperandeo explains how investment views can be applied to factor investing to achieve outcomes such as enhanced returns or reduced risk.
Why are factors used by active asset managers?
The point is to capture persistent drivers of investment returns that have been documented by academics since the 1930s. Thanks to improvements in data and technology, factors can be systematically targeted to deliver outcomes that can be different from the market. The two key outcomes are return enhancement and risk reduction.
For return enhancement, the factors we target are quality, momentum, value and size; low volatility, on the other hand, can deliver risk reduction. The economic rationale explaining these factors varies over time and so timing comes into play, similar to how active managers rotate through sectors and countries.
Timing factors is as difficult, if not more difficult, as timing sectors. The influences on the performance behind these factors are not immediately understandable, so we put a lot of effort into this. Andrew Ang, Head of Factor Investing Strategies who joined BlackRock from Columbia Business School last year, has been leading this effort of helping investors to consider factor tilts to their portfolios.
What is the current positioning of asset management in terms of factors?
Using US-domiciled mutual funds as an example, we use data on reported positions to look at stock level ownership of funds and then to identify any crowding concerns (i.e. the concern that so many investors have invested in some of these factors that their effectiveness might be compromised).
Looking at minimum volatility ETFs, for example, the first data point is positions, and the data shows that S&P 500 active mutual funds hold, on average, 13.8% of each stock in the index and that ETFs hold 6%. Of all stocks, 0.2% are held in minimum volatility ETFs. (Data as of 31/3/2016. Source: BlackRock, Bloomberg, Morningstar, Thomson Reuters.)
The next data point is net exposure of active funds to factors and our research finds that net exposure is still quite skewed towards more volatile stocks and stocks with higher betas. This is a measure for potential capacity for these type of factor based strategies.
What are the indicators you use to predict the future performance of factors?
Together with business cycle, as mentioned earlier, we look at technical indicators, such as dispersion. Dispersion helps you measure the opportunity set that factor strategies have in the current market. When stocks behave similarly, there is very little benefit in deviating from the market-cap index. But when there is a high degree of dispersion in the return pattern of stocks, any over- or under-weights relative to the market portfolio have the potential to drive meaningful performance differences.
Another set of metrics we look at concern valuations. All else equal, one prefers something with a low price relative to fundamental value. However, there are also other predictors; just because something is cheap doesn’t mean it doesn’t get cheaper. This highlights the importance of multiple indicators in a short-term outlook for factors. The US single factor that remains the strongest from a valuation point of view is value – but with indicators suggesting economic growth in the US is increasing and the outlook for recession is decreasing, in this expansionary period we think momentum will also come into favour.
How is the outlook for interest rate increases affecting factor rotations?
Prevailing interest-rate regime can make a big difference in how equity factors behave. Quality and low volatility factors are more ’bond-like’ in that they tend to decline as interest rates rise. On the other hand, we observe that the value factor may have higher returns than the broader market as interest rates rise, provided that the rise is modest.
How can investors use factors to express investment views?
For investors that have lower risk tolerance and a longer timeframe, we think they should maintain a diversified exposure through multi-factor strategies that can deliver an excess return over a full cycle. These investors are less intent on timing the market and so the best option is to keep a systematic blend of factors at the core of their portfolilo.
Those with higher risk tolerance and who are in pursuit of shorter-term gains could consider factor tilts. At the core of their portfolio would be a diversified exposure towards single factors – but the portfolio is tilted in favour of factors that are believed to have a higher chance of outperformance in the near future.
So, for investors who are more constructive on risk and positive about the business cycle, it would make sense to tilt towards cyclical factors such as value, size and momentum. Those who are more defensive might want to consider a tilt towards quality and low volatility.
We issue a factor outlook on a quarterly basis, a report that summarises BlackRock’s forward- looking views on US equity style factors. Factor tilting requires skill and moves you into the realm of alpha generation, but such an approach can allow investors to embrace both the long- and short-term potential of factor investing.
BlackRock recently launched a US single factor suite and has 19 smart beta products in total.
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