‘Value and quality combination delivers outperformance’

The value factor has been disappointing investors for years. However, combining value with quality turns underperformance into stable outperformance, according to French boutique asset manager Seeyond AM. Seeyond has called the ‘new’ factor smart value.

The main reason why value has performed so badly since the financial crisis is the low interest rate. As a result, many cheap but poorly-performing companies are artificially being kept alive. ‘More than one in ten companies would go bankrupt immediately if QE were to disappear and interest rates were to return to normal. These companies often score well with respect to traditional value criteria such as price-to-book and price-earnings ratio, which means that they are automatically included in an index of value shares’, says Christiaan Kraan of Seeyond AM, a subsidiary of factor investment specialist Natixis Investment Management. ‘But you really need to be able to filter these companies out.’

Quality filter

Seeyond does this by adding a quality filter to the value factor. ‘We look at return on equity and its stability, and at financial leverage, or how much debt a company has’, Kraan explains. ‘This in fact is a logical combination, since in the case of both value and quality, it’s all about whether a share is reasonably priced. In the case of quality, you want a good share for a reasonable price, and with value, you want a standard share for a low price.’

In the beginning Seeyond, founded in 2011, did not even include the quality factor in its multi-factor strategies. Kraan: ‘We originally focused purely on low volatility. That was most popular with our clients, who are located mainly in France, Italy and Spain. In 2014, we began multi-factor investing.’ That happened more or less by chance. ‘Our clients wanted a low tracking error compared to the benchmark. If you only take one factor into account, then outperformance won’t be possible. To meet this demand on the part of clients, we added the value and momentum factors. We see these as the purest factors.’ Seeyond does not include the factor size either. ‘We select the 50 shares with the highest score from our model for each factor and take an allocation of 2% for each. As a result, we are already weighted more heavily in smaller shares’, explains Kraan.

Getting rid of value traps

The new multi-factor approach initially did not result in outperformance, in particular due to the constant underperformance of the value factor. Hence the decision to add a quality filter to the value factor.

According to a back test from 1995 that it carried out on the new factor, the overlap in selected companies between ‘smart value’ and the original ‘value’ factor is only 27% on average. The attractiveness of financials in particular decreases after the addition of the quality filter: a confirmation of the suspicion that many cheap European banks are in fact ‘value traps’. With the new ‘smart value’ factor, 26% of the companies selected are still banks or insurers. This weighting is similar to the consumer discretionary category. Using the original value factor, the two sectors had a representation of 52% and 20% respectively.

Underperformance becomes outperformance

Performance also improves considerably, especially after 2009. ‘In the period before 2008, when the interest rate was much higher and value as a factor did very well, the quality filter did not make much difference. But since then, investors have begun looking much more closely at quality, and that factor has also performed better.’

Between the start of 2010 and the end of September 2019, the Seeyond smart value factor achieved an annualised return of 8.92%, compared to only 3.82% for the value factor. Smart value even outperforms the MSCI Europe Index, which managed to achieve a return of ‘only’ 7.69% over the past ten years. Smart value also beats the Japanese stock index in the long term. Only in the case of US equities does this not apply, although smart value always outperforms the unadjusted value factor.

Source: Seeyond AM

The differences in sector composition between value and smart value are a lot smaller for Japanese, and especially for American, equities, than for European equities. Kraan: ‘In the US, for example, financials assessed with the smart value factor have exposure similar to that when assessed using the value factor.’

Seeyond replaced the old value factor with the new smart value factor for all its smart beta strategies (European, Japanese and American stocks) more than a year ago. This has indeed improved performance compared to the benchmark.

The Seeyond Equity Factor Investing Europe fund, after deducting 0.4% for costs, has lagged the benchmark by 1.5 percentage points over the past three years. In the past year this underperformance turned into an outperformance of 0.59 percentage points. 

Seeyond, which serves only institutional clients and does not offer ETFs, is not planning to offer smart value as a stand-alone product. ‘For our client group and their investment horizon, we believe that factors function best when they are combined’, says Kraan. ‘The only exception to this is low volatility, which we do offer as a separate product.’