IN BRIEF

  • Factor-based investment strategies offer a compelling opportunity for institutional investors to enhance portfolio returns in a cost-efficient manner.
     
  • Most investor allocations to the equity factor space are made in the form of long-only strategies. These can serve as core or targeted equity exposures.
     
  • Strategies that combine factors (so-called multi-factor approaches) tend to exhibit more stable risk-return profiles than single-factor approaches.
     
  • Investors may reap the benefits of factor-based strategies whether their allocations are sourced from passive or active equity exposures.
     
  • A case study presents an example of how an institutional investor may approach factor-based investing.

Investing is all about risk and reward—and investors have certainly been rewarded for taking risk this cycle. The S&P 500 is up 426% from its March 2009 low, while the Bloomberg Barclays US Aggregate Bond Index rose 46% over the same period.

Today, however, late-cycle dynamics are making the return environment increasingly challenging. The pace of economic growth has slowed this year as fiscal stimulus in the U.S. has run its course, and although the Federal Reserve has paused its rate hikes, it seems premature to call the end of the current hiking cycle. Meanwhile, elevated levels of political uncertainty continue to weigh on business investment.

These dynamics have pushed volatility higher while expected returns have come under pressure. Yields on core fixed income remain low, which will likely keep a ceiling on bond market returns going forward. And despite a sharp rerating in equity valuations at the end of 2018, the forward P/E ratio on the S&P 500 is back to its long-term average, suggesting the asset class will generate mid-single digit returns in the coming years.

Investors face specific—and significant—challenges in this environment. Confronting reduced return expectations across a range of asset classes and fearful of taking on increased portfolio risks late in the cycle, institutional investors—from corporate pension plans to health care organizations to endowments and foundations—are evaluating ways to improve portfolio outcomes while remaining cognizant of investment costs.

In response to these challenges, and looking for the potential to improve returns, more institutional investors are considering gaining explicit exposure to factors across a variety of asset classes.1 As the understanding of investment risks and returns has evolved over time, and as practitioners have developed new ways to access factors in liquid and transparent vehicles, investors have gained access to factor-based strategies to enhance returns while limiting investment costs. In our work with a range of clients, we observe a notable increase in the proportion seeking explicit exposure to factors within their equity allocation buckets. Importantly, institutional investors may reap the benefits of factor-based strategies whether their allocations are sourced from passive or active equity exposures. In this article, we explore the role of equity factors in driving returns, highlight how investors can access factor exposures and examine the varying approaches to factor-based investing.

Why do factors matter?

The universe of factors can be divided between those that reward investors (compensated factors) and those that do not. To understand why certain factors are rewarded over time, it is crucial to understand the economic rationales that underpin them. These rationales span risk preferences, behavioral biases and structural features of the market; they are also non-mutually exclusive across factors (that is, a single factor may reflect more than one rationale). While the equity risk premium is not always thought of as a factor, given how internalized it is as a concept among market participants, it was in fact the first identified compensated factor. A simple explanation of the equity risk premium: In return for putting capital at risk in equity markets (and withstanding periods of negative performance and occasional but at times substantial drawdowns), investors are rewarded with returns that are considerably in excess of cash investments. Similarly, the value, quality and momentum factors compensate investors who assume risks that others cannot, should not or choose not to take on (Romahi, Staines and Norman 2018).2

Along with clear economic rationales, factors can be shown to deliver persistent returns over extended periods of time and across various markets. For this reason, factors have been widely discussed in academic literature, as highlighted in EXHIBIT 1.

Factors can be shown to deliver persistent returns over extended periods of time and across various markets

EXHIBIT 1: FACTOR EXPOSURES BY ASSET CLASSES

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Source: J.P. Morgan Asset Management. For illustrative purposes only.

How investors access equity factors

Factor strategies have demonstrated value across a range of geographies and parts of the market cap spectrum. Equity factors can be accessed in two forms: 1) long-only and 2) long-short. In long-only equity factor strategies, portfolios invest in stocks that exhibit attractive value, quality and/or momentum characteristics, in effect sourcing exposure to these factors in addition to the equity risk premium.3 These strategies carry the objective of enhancing returns (or, in the case of low volatility/ minimum volatility portfolios, reducing risks). In long-short equity factor strategies, on the other hand, portfolios similarly invest in stocks that exhibit attractive factor characteristics but additionally short those with unattractive factor characteristics such that their exposure to the equity risk premium is negated. These strategies allow investors to isolate the desired factor exposures in a manner that reduces equity beta or correlation, with the objective of sourcing diversifying returns.

Most institutional investor allocations to the equity factor space are made in the form of long-only strategies. These strategies, depending on their design, can serve as core or targeted equity exposures. Strategies that combine factors (so-called multi-factor approaches) take advantage of diversification benefits across factors4 and tend to exhibit more stable risk-return profiles than single-factor approaches. As a result, they are well suited for the core portion of an overall equity allocation. Single-factor approaches, on the other hand, are more cyclical in nature and are typically allocated in a targeted fashion, with a specific objective in mind—such as taking a view on a certain factor outperforming over the near term, or balancing factor exposures that are already present in plan portfolios.

FACTOR 101: VALUE, QUALITY, MOMENTUM

Value

The value factor relates to the tendency for underpriced, or “cheap,” stocks to outperform their more expensive counterparts over time. This observation, which dates back to Graham and Dodd’s seminal work in the 1930s, applies across a range of value metrics, time periods and geographies. Both behavioral biases and risk preferences drive performance for the value factor.

  • BEHAVIORAL: Value companies tend to exhibit worsening fundamentals, reflected in market pricing; however, evidence suggests that investors overextrapolate earnings trends, instead preferring to invest in high growth, “glamour” stocks. Eventually, value companies cease deteriorating at the expected pace—at which point investors rerate them at higher levels.
  • RISK: Worsening corporate fundamentals expose value stocks to greater distress risk1 in the event of a recession or credit freeze and as such necessitate greater returns over time.

Quality

The quality factor can be defined in many ways; broadly, it relates to the tendency for higher quality stocks to outperform their lower quality (“junk”) peers. As high quality stocks by definition have better fundamentals than low quality stocks, they should theoretically offer lower returns. Behavioral and structural rationales explain why this is not the case.

  • BEHAVIORAL: Outperformance partly reflects the so-called lottery ticket effect—whereby investors overestimate and overpay for remote chances of high reward. In a typical scenario, investors overvalue low quality stocks that have greater price uncertainty, seeing greater potential for outsize gains, and high quality stocks become undervalued, thus positioned to offer increased return potential over the long term.
  • STRUCTURAL: The lower volatility typically associated with quality stocks can reduce demand from investors that have limited, if any, ability to take on leverage and thereby prefer securities with higher risk-reward prospects in order to outperform their market benchmark. Again, this leaves higher quality stocks underpriced, increasing their return potential.

Momentum

The momentum factor relates to the tendency of stocks that outperform to continue to outperform. This effect can be explained by both behavioral and risk-based rationales.

  • BEHAVIORAL: Investors tend to initially underreact to new information and subsequently overreact once this information becomes more widely recognized.
  • RISK: In a typical scenario, the overreaction in pricing trends builds, causing a mismatch between buyers and sellers. Once new information emerges or the market environment changes, an imbalance is created that leads to sharp corrections. These corrections expose momentum investors to the risk of asymmetric losses in their return profile—a risk that many are not willing or able to take on.

Empirical support

J.P. Morgan’s Quantitative Beta Strategies team typically employs an average of inputs to define these three factors, with an eye toward intuition and a desire to reduce sensitivity to any one data point. As highlighted in EXHIBIT 2, value, quality and momentum have each exhibited attractive risk-adjusted returns (net of transaction cost assumptions) across a range of geographies dating back to 1990.

EXHIBIT 2: GLOBAL RISK-ADJUSTED RETURNS

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Source: J.P. Morgan Asset Management. For illustrative purposes only.

1 Value companies typically derive more of their value from assets in place than do growth stocks (which are valued based on future growth options) and as a result have less flexibility to adapt or respond during difficult economic times, exposing them to distress risk.

While factor strategies can improve risk-adjusted returns relative to traditional market cap exposures (and thus serve as replacements to passive equity allocations), they can also be thought of as low cost replacements or complements to active allocations. Over time, as investors’ understanding of investment risks and returns has continued to evolve, they have been able to determine that certain active equity manager returns can be well explained by their factor exposures. Some managers, for example, have been able to repeatedly outperform the market by biasing their portfolios toward companies that have lower P/E multiples or higher quality metrics. As new technologies are better able to identify factor exposures, investors can now distinguish between those managers that have been rewarded for simply tilting toward these factors5 and those that have exhibited an ability to select stocks that provide true alpha. Investors can then consider replacing the factor “tilters” with lower cost, factor-based strategies.

Factor strategies can be implemented in multiple ways, ranging from pooled vehicles to separate accounts or delivered models. While each may offer the benefits of low cost and transparency, the latter two offer flexibility in tailoring investment universe choices, tracking error constraints and other parameters to specific client objectives. In cases where pooled vehicles do not align with an investor’s needs or fail to target the desired out- come, customization by way of a separate account or model delivery engagement may offer the solution. Alternately, factor strategies can be designed to target either an improved Sharpe ratio or an improved information ratio.

Case study: equity factor investing

Equity factor strategies can offer benefits across both the risk and return dimensions, giving investors a way to capture market upside without taking undue concentration risk across certain sectors or stocks. We have seen institutional investors moving to factor strategies as replacements for both passive and active exposures, with factor-based strategies serving as a hybrid of the two, given their ability to enhance returns vs. passive exposures while doing so in a liquid, low cost and transparent manner.

Replacement of passive equity exposure

Employing factors to improve equity diversification or minimize volatility may help investors who want to retain exposure to equity markets as a driver of portfolio growth but are worried about risk concentrations. Traditional market cap-weighted approaches are well diversified at the surface level (e.g., 500-plus stocks, 10 sectors). However, they can become concentrated when relatively few firms or sectors hold a relatively large share of the market’s total capitalization, as happened in the dot-com bubble and the global financial crisis. Over the past 20 years, a multi-factor equity approach (EXHIBIT 3 ) that seeks to diversify sector and stock risk while capturing the equity value, quality and momentum factors has experienced 13% lower volatility than a traditional market cap index. An approach that explicitly seeks to minimize volatility, regardless of return potential, has experienced 23% lower volatility. While both approaches may help to reduce surplus volatility, multi-factor strategies offer benefits that may help investors from a return perspective and lead to a better outcome when taking both risk and return objectives into account.

A multi-factor approach provides exposure to value, quality and momentum

EXHIBIT 3: CUMULATIVE PERFORMANCE

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Source: J.P. Morgan Asset Management. For illustrative purposes only.

Replacement of active equity exposure

Investors look to active managers for their ability to both enhance return and reduce risk. Given the potential for factor strategies to improve outcomes at low cost, however, the bar for active managers is high. Using sophisticated tools for factor analysis, we are able to diagnose existing equity portfolio exposures through a factor lens and decompose individual manager returns into beta, factor and alpha components. EXHIBIT 4 presents this analysis, decomposing the returns of an active equity manager with a bias toward higher quality companies. In this analysis, we see that, despite outperforming a market cap benchmark by 90 basis points (bps, annualized) over a five-year period, the manager did not generate any alpha and instead benefited from exposure to the quality factor, which was up nearly 4% over the analysis period and contributed roughly 120bps to the manager’s returns. In this example, an investor may be able to improve net of fee return by replacing the active manager with either a skilled stock picker that can generate true alpha or a lower cost factor exposure.

We can decompose individual manager returns into beta, factor and alpha components

EXHIBIT 4: GLOBAL DEVELOPED EQUITY MANAGER

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Source: J.P. Morgan Asset Management. For illustrative purposes only.

Conclusion

Skilled stock pickers that can reliably generate alpha will always have an important role to play in institutional portfolios. But as our understanding of investment risks and returns has evolved over time, and as practitioners have developed new ways to access factors in a liquid, low cost and transparent manner, factor-based investment strategies offer a compelling opportunity to enhance portfolio outcomes while reducing or limiting overall investment costs. Investors can reap these benefits whether their factor allocations are sourced from passive or active equity exposures. As we have discussed, a confluence of developments has spurred increased interest in equity factor exposures by institutional investors. We believe the trend will only deepen and broaden in the coming years.

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