Due to a sustained period of underperformance, investors are increasingly questioning the validity of factor investing. Georg Elsaesser, Portfolio Manager Quantitative Investment at Invesco, has a simple explanation for the underperformance, and is not worried, yet.
‘The value factor and small-caps in particular have done badly, but that can be explained by the market environment. All factors are still doing what they are supposed to do,’ says Elsaesser.
Until the outbreak of the coronavirus crisis in February, there was an extremely long bull market, but it wasn’t one marked by optimism, notes the German. This the most important explanation for the long streak of underperformance by cyclical factors such as value and small-caps, he argues. ‘Value simply does relatively poorly in such a risk-off bull market’, says Elsaesser. ‘Value means you buy the stocks that others sell, it’s a contrarian investment style. So you’re not invested in or less exposed to the most popular stocks and sectors.’
FAMANG
In recent years, those most popular stocks have coincidentally also been those with the largest weighting in the index, especially the FAMANG stocks in the US. These FAMANG stocks have been doing extremely well, especially since 2018. This has contributed strongly to the relative underperformance of value and small-caps.
Over the past five years, the MSCI ACWI Value Index has achieved a total return in euros of less than 4%, compared to 27.5% for the broad global equity index over the same period. With a total return of 12.9%, small-caps also show a substantial underperformance. Nevertheless, Elsaesser remains confident that the two factors will pick up over time.
‘All factors move in cycles, which on average last three to five years. In the case of value, the underperformance now lasts longer, but that does not mean that it will last forever,’ he says. ‘That only happens if valuations no longer play any role at all for investors, but I don’t assume that’s the case.’
Still, Elsaesser’s patience seems to be put to the test, as the coronavirus crisis has only reinforced the underperformance of value and small-caps. ‘The crisis has reinforced the positive momentum for a small number of stocks that were already showing above-average performance, such as Microsoft and Apple. We are now in a deep recession, justifying a more defensive positioning.’
59% want to increase factor allocation
The outperformance of the factors momentum, quality and low volatility has not compensated for the poor performance of value and small-caps: over the past five years, the MSCI ACWI Diversified Multi Factor Index has achieved a total return of 20.4%. That is 7%-point below the performance of the market-weighted MSCI ACWI Index.
Still, this underperformance does not seem to deter investors. According to a survey conducted by Invesco last year among institutional investors, 59% still intend to expand their allocation to factor investing.
However, the same survey also showed that the vast majority of factor investors have an investment horizon of up to five years. The underperformance of value has already exceeded this limit, so you’d expect the value factor to be questioned by at least some investors.
‘But we haven’t seen large outflows yet,’ claims Elsaesser. ‘But we do notice that some clients are postponing a decision on starting new mandates. Many customers are currently paralysed and are doing nothing. It is possible that at some point they will reallocate from value towards lower volatility. But it could also be that they are moving towards market-beta strategies.’