Primer: the factor drivers of investment returns

April 2017

For Financial Intermediary, Institutional and Consultant use only. Not for redistribution under any circumstances. Primer: the factor drivers of investment returns 2 Primer: the factor drivers of investment returns

Many of the concepts behind factor investing are nearly as old as investing itself. Much newer is the idea of bringing them together systematically. This is transforming the way investors think of portfolio construction, and the reasons are clear: factor investing offers diversification, transparency and economy. We review the underlying concepts and show how they underpin a number of apparently disparate developments from smart beta to alternative risk premia. Factor investing provides important new Ashley Lester, tools for the investor, but, like all tools, having a firm understanding of Ph.D. Head of their purpose remains critical to results. Research, Multi-Asset Why factor investing? The aim here is to achieve more stable diversification than asset class allocation alone. Traditionally, investors have thought of the The risk premia underlying assets may have world in terms of asset classes, such as equities a more stable relationship than that between and bonds. Factor investing looks beneath asset asset classes, since the mix of risks and expected classes to allocate according to the factors that returns in an asset class can vary. In October drive risk and return. Some of these so-called ‘risk 2008, for instance, corporate bond risks and premia’ may correspond more or less directly to expected returns were dominated by credit risk, an asset class, such as the equity risk premium. while by 2016 long-term interest rates (duration) Other asset classes represent a combination of were more important (Figure 1). These variations factors. For instance, corporate bonds combine affect the risk, return and diversification of long-term interest rate risk (itself divisible into portfolios considerably. Factor investing seeks inflation and duration risk) and credit risk, and more direct exposure to the drivers of return, these two sources of risk are separable, at least in which have shown more stable relationships principle1. with each other and therefore more consistent diversification.

Figure 1: Dissecting corporate bonds into their risk premia

% US investment grade credit 10

8

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4

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0 31 October 2008 29 July 2016 Risk-free rate Credit risk premium Duration risk premium

Source: Schroders. For illustrative purposes only. Does not reflect any actual portfolio. For instance, by hedging out the duration risk, or investing in credit default swaps. For more on this subject, see “Putting a premium on risk”, Investment Horizons, issue 1, 2014.

For Financial Intermediary, Institutional and 3 Primer: the factor drivers of investment returns Consultant use only. Not for redistribution under any cir- cumstances. What are the factors? hold them. If one investor holds a value strategy, all the other equity investors in the world must be The factors we have discussed so far are traditional collectively underweight value, relative to the market. elements of portfolios. But much of the recent So here is our first note of caution: if factors are well excitement comes from less traditional factors, which known, either they may not continue to outperform, are increasingly used as portfolio building blocks. The or there must be another reason why some choose best known are equity strategies such as value, size, not to use them. quality, low volatility and momentum. These sorts of ‘dynamic’ factors, widely marketed as ‘smart beta’, At their most basic, factors are rule-based strategies require active management to maintain exposure, as that can generate outperformance over lengthy a stock that was good value last month, for example, periods. A more helpful way to analyze them is to may be overpriced this month. These differ from look at how the basic rule can be turned into different traditional factors in another way: not everyone can strategies of varying sophistication and risks (Figure 2).

Figure 2: The evolution of factor portfolios, from smart beta to alternative risk premia

Long-only Long-short Starting universe Rank by factor “smart beta” “alternative risk premia”

Cheap

Marke t

Expensive Cheap Cheap Long Long

Short Short

Expensive

Source: Schroders. For illustrative purposes only. Does not reflect any actual portfolio.

Suppose we have a rule that ranks the desirability of Hence our second cautionary note about factor stocks and then use it to build a portfolio: we have investing: since all known factors experience periods created a form of ‘smart beta’. The term derives from the of underperformance, seeking a diversified portfolio of idea that we have captured something systematic about factor exposures is a much better idea than focusing on stock returns over and above general market moves. just one or two. ‘Alpha’, by contrast, is taken to represent above-market returns deriving purely from stock selection. Bringing these arguments together, we can say that factor investing aims to: A key point about this portfolio is that the single largest — enhance investment returns through historically driver of its returns is still the broad equity market as a demonstrated systematic strategies, whole. We hope that our rule tilts the risk and return of the portfolio in our favor, but if equity markets fall, for — improve diversification by breaking down risk into its example, our portfolio will also tend to fall. If we are a bit underlying components, and more sophisticated, and use our factor not only to buy — reduce fees, since strategies can be implemented the desirable stocks, but to short the undesirable stocks, more efficiently. we have entered the world of long-short equity hedge funds or, more generically, of ‘alternative risk premia’. Of course, building a portfolio that includes shorts is While the concept and intentions are straightforward, operationally more difficult than building a long-only the execution is not quite so simple. portfolio. And if the factor underperforms, the portfolio will not merely underperform the market, but actually lose money.

Primer: the factor drivers of investment returns 4 Which factors? the University of Chicago3). In time, a new taxonomy may well emerge, but there is no particular reason to expect One of the canons of practical finance is that there are that it will resemble the remarkable simplicity of the four or five fundamental factors, discovered in stock model Fama and French propounded almost a quarter of markets, that can be applied equally well in other a century ago. markets, such as those for bonds and currencies. These It is no accident that equities have been a hotbed for factors are value, momentum, low volatility, and often new factors. Research is facilitated by freely available size or quality. Conventional wisdom is, however, wrong data, relatively straightforward return modeling and in two important ways. First, there are many more than highly dispersed returns from many different stocks, four or five plausible factors. Second, factor investing is allowing for the empirical examination of many different just as relevant to other asset classes as to equities, but factor ideas. Achieving the same results for government often involves quite different factors. bonds, commodities, currencies or, indeed, any other The notion that there are just four or five simply- asset class is much harder. Few should be surprised, described equity factors reflects the seminal findings of therefore, that nothing like 300 factors able to generate Eugene Fama and Kenneth French, then of the University outperformance have been found anywhere beyond of Chicago, starting in the early 1990s. In a series of equities. 1 research articles , Fama and French showed that the Nevertheless, systematic strategies have been returns from many different equity portfolios could be established across all asset classes. One type of factor mostly explained using returns from the market, along that is common across many is ‘carry’ – roughly speaking, with size and value. This was a major development in the amount an investor is paid to hold an asset, finance, as the significance of size and value shredded independently of price changes. This idea was originally the previous academic view that market returns were the applied to currency investing, where carry corresponds only systematically important and consistently rewarded to a given currency’s short-term interest rate. In equities, risk in equity markets. (This was the basis of the famous dividend yield is often identified as ‘carry’. Similarly, capital asset pricing model developed in the early to mid momentum – the idea that recent winners go on winning 2 1960s.) – seems to be an empirical regularity across many asset Fama and French influenced a generation of students classes and geographies. Other types of factors seem and practitioners, and their work laid the foundation asset-class specific – for example, roll-down is the profit for some of the most successful strategies of from holding a bond if an upward sloping yield curve recent decades. But the students they influenced remains fixed. understandably were not content with accepting that The existence of factors across many asset classes is two academics had discovered every conceivably important because it increases the possible opportunities important factor in equity markets. Their search for for factor investing. And because of the low historical additional factors was spectacularly successful. Over 300 correlation between factors across asset classes, a different equity ‘factors’ have now been identified in the multi-asset approach to factor investing should provide academic literature, with around one new factor having investors with greater opportunities for diversification been discovered each month on average over the past benefits than focusing solely on equities. 10 years. The academic quest now is to bring order to the ‘factor zoo’ (a term coined by John Cochrane, also formerly of

Are factors generic? company’s assets to its market value. There are, The concept of value investing dates back at least to however, equally useful ways of measuring ‘value’, Benjamin Graham and David Dodd’s classic work in including, for example, earnings relative to a company’s 1 1934 . Fama and French chose to formalize the idea by market value. In one sense, the choice of measuring value as the ratio of the book value of a

2 E.g. “The Cross-Section of Expected Stock Returns”, Eugene F. Fama and Kenneth R. French, Journal of Finance, vol. XLVII, June 1992; “Common risk factors in the returns on stocks and bonds”, Journal of Financial Economics, vol. 33, February 1993; and “Size and Book-to-Market Factors in Earnings and Returns”, Journal of Finance, vol. L, March 1995.

3 For a more recent discussion of this see “The Capital Asset Pricing Model: Theory and Evidence”, EF Fama and KR French, Journal of Economic Perspectives, vol. 18, summer 2004.

4 “Presidential Address: Discount Rates”, John H Cochrane, President of American Finance Association 2010, Journal of Finance, vol. LXVI, August 2011.

Security Analysis, Benjamin Graham and David Dodd, Whittlesey House (McGraw-Hill), 1934.

5 Primer: the factor drivers of investment returns measurement does not matter much – groups of stocks returns from three different value indices created by measured by different ideas of value tend to move up MSCI, a leading index provider. The monthly returns and down in similar ways; that is, portfolios formed from these indices are more than 90% correlated, from different types of value measurements tend to and their ‘active’ returns (those that differ from the be quite highly correlated. In a much more important capitalization-weighted benchmark) are around 60% way, however, the choice of measurement is critical: correlated. But over 19 years, the Value Weighted index cumulative returns of these portfolios can be very has added only around 10% to the performance of different. the benchmark, while the Enhanced Value index has added over 110%. So even small differences in index Performance can differ even across portfolios of stocks construction and portfolio management can lead to selected from the same universe, by the same firm, enormous differences in performance. using similar methodologies. Figure 3 shows cumulative

Figure 3: Same factor, wildly different results

Three MSCI value indices compared to MSCI All Country World Index 300

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0 1997 2000 2003 2006 2009 2012 2015 ACWI Enhanced Value ACWI Prime Value ACWI Value Weighted

Rebased to 100 from January 1, 1997. Total active returns compared to MSCI All Country World Index. Source: Bloomberg and Schroders, as of December 31, 2015. Past performance is no guarantee of future returns. Investors cannot invest directly in any index.

Investors may be wondering: if there can be such widely likely to have little effective exposure to the factor. This different returns produced by the best known factor is largely because returns from many factors are more from the same index provider, working on the same pronounced in smaller stocks, which are likely to be less set of stocks, is factor investing truly systematic and well represented in the portfolio. reliable? The answer is that it can be, but it depends on Again, we can use value as an example. Figure 4 shows the implementation: some factor implementations are the differences in returns from investing in different- more efficient than others. Because factor investing is sized stocks in four different value portfolios over the quantitative, it is possible to study the different building past 19 years. We divided each portfolio by size and blocks that go into factor construction and find out which compared the performance of the smallest 25% of stocks approaches are more likely to produce acceptable returns with the largest 25%. In each case, buying ‘value’ stocks in the long run. and selling expensive stocks was handsomely rewarded among the smallest stocks, but generated almost no An important example of this is how the stocks in a return at all among the largest stocks. This is evident portfolio are weighted. If, for example, the selected across many factors, where returns are often more stocks are capitalization-weighted, the resulting index is pronounced in smaller stocks than larger ones.

Primer: the factor drivers of investment returns 6 Figure 4: Size can make a weighty difference

Differences in returns from four long-short value portfolios divided by stock size % 9 8 7 6 5 4 3 2 1 0 -1 Book to price Dividend yield Earnings yield Operating cash flow Smallest 25% Largest 25%

Investment universe is divided into quartiles by size, then each size bucket is further divided into quartiles for a given value factor. Value portfolios created by ranking investment universe from highest to lowest based on, respectively, book value to price, dividend yield, earnings yield and operating cash flow. Each column represents the difference in performance between the 25% cheapest and the 25% most expensive stocks in the smallest and largest size buckets for each value factor. Data are for July 1997 to June 2015. Source: Schroders. Performance shown reflects past performance which is no guarantee of future results. Actual results would vary.

Clearly, just as with any other strategy, investors must pay ‘systematic’ is as good as any other. Fortunately for close attention to implementation. We have found investors, careful analysis can illuminate differences plenty of evidence of persistent systematic strategies, but among strategies in advance. that does not mean that any strategy labeled

Who should hold factors? If a well-known factor can persist, why wouldn’t everyone invest in it? In truth, investors have different goals and needs. Consider those saving for retirement. One other note of caution on factors relates to their Some are at the start of their working lives and will not dynamic nature. As suggested earlier, as a particular need retirement savings for years; others are close factor becomes widely used, either its previous to retirement, with little opportunity to make up for outperformance is likely to tail off or there must be some investment losses. Suppose a factor performs well in other reason why non-users adopt an opposite strategy. most markets, but does badly when prices plunge. This Does this imply that factors become less attractive as their risk may be acceptable for young savers, who have a popularity increases? Here we can draw lessons from the long investment horizon, but older investors should past. One study considered 100 published equity factors avoid it, given the possible impact of losses. This points and found longer-term evidence for about a quarter. So younger investors towards factors like size and value, while the majority were not reliable, dozens of publicly- and older ones towards low volatility and quality. available equity factors were still found to produce Similarly, most contributors to defined contribution significant positive returns, even after they became well pension schemes probably want relatively known. straightforward investments, implemented cheaply, with Some of these factors are likely to be of little use for most easily-understood risks. For these investors, long-only investors. Others, however, may continue to provide factor investing is a sensible way to try to provide extra attractive returns. Many of the latter have probably been return. At the other end of the spectrum, sophisticated known about, albeit with different labels, for a long time. institutions or family offices may be willing to take on After all, investors were seeking ‘cheap’ stocks long before more opaque risks, particularly if they help to diversify Fama and French appeared in the early 1990s. So even their existing portfolio more effectively. For those if investment flows into ‘value’ factors are new, flows to investors, taking on intensified factor exposure using managers seeking to exploit value as an idea certainly are alternative risk premia may make more sense. not. This is another reason to think that such well-known factors will probably not be competed away.

7 Primer: the factor drivers of investment returns Conclusion portfolio of dynamic risk premia means sorting those with lasting value from those that are ephemeral or illusory, concentrating factor Factor investing is a powerful tool for managing exposure on securities where it is rewarded, investments. By breaking down assets into risk broadening exposure across asset classes, and premia, it can provide greater transparency of staying on the leading edge of financial research. portfolio construction and greater control over the Meeting these challenges should enable investors drivers of risk and return. Dynamic risk premia, of all types – from the least engaged to the most such as value or momentum, can diversify the sophisticated – to gain access to new sources of sources of return in a portfolio beyond traditional return in the form that best fits their investment assets. But successful implementation of factor needs. investing requires care and skill. Creating a

About the author

Ashley Lester, Ph.D. Head of Research, Multi-Asset

Ashley joined Schroders in 2015 and is based in to manage risk and support investment decisions. London where is Head of Research within the Multi Prior to his role at MSCI, Ashley was Head of Market Asset Team. He also chairs the Strategic Investment Risk Methodology at Morgan Stanley, where he Group Multi-Asset (SIGMA) and the Model Review was responsible for the firm’s market risk models, Group. Ashley is responsible for the development including their research, production and regulatory of Schroders’ proprietary portfolio construction and approval. Ashley was intensively involved in the optimization tools, the formulation of our Advanced implementation of Basel 2.5 and the CCAR stress Beta systematic strategies, and furthering our testing process. thought leadership in global asset allocation. Earlier in his career, Ashley was an Assistant Prior to joining Schroders, Ashley was at MSCI Professor of Economics at Brown University and where he was Head of Multi Asset and Fixed a Visiting Assistant Professor of Economics and Income Research. In this role, Ashley directed Finance at Columbia Business School. He started research relating to fixed income, alternatives and his career as an economist at the Reserve Bank of risk methodology for the Barra and RiskMetrics Australia. platforms, used by financial institutions globally

Primer: the factor drivers of investment returns 8 schroders.com/us @schrodersUS

Important information: The views and opinions contained herein are those of the Schroders Multi-Asset Team, and do not necessarily represent Schroder Investment Management North America Inc.’s house view. Originally issued December 2016. These views and opinions are subject to change. These views and opinions are subject to change. Companies/issuers/sectors mentioned are for illustrative purposes only and should not be viewed as a recommendation to buy/ sell. This report is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for accounting, legal or tax advice, or investment recommendations. Information herein has been obtained from sources we believe to be reliable but SIMNA Inc. does not warrant its completeness or accuracy. No responsibility can be accepted for errors of facts obtained from third parties. Reliance should not be placed on the views and information in the document when making individual investment and / or strategic decisions. The opinions stated in this document include some forecasted views. We believe that we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee that any forecasts or opinions will be realized. No responsibility can be accepted for errors of fact obtained from third parties. While every effort has been made to produce a fair representation of performance, no representations or warranties are made as to the accuracy of the information or ratings presented, and no responsibility or liability can be accepted for damage caused by use of or reliance on the information contained within this report. Past performance is no guarantee of future results. SIMNA Inc. is an investment advisor registered with the U.S. SEC. It provides asset management products and services to clients in the U.S. and Canada including Schroder Capital Funds (Delaware), Schroder Series Trust and Schroder Global Series Trust, investment companies registered with the SEC (the “Schroder Funds”.) Shares of the Schroder Funds are distributed by Schroder Fund Advisors LLC, a member of the FINRA. SIMNA Inc. and Schroder Fund Advisors LLC. Are indirect, wholly-owned subsidiaries of Schroders plc, a UK public company with shares listed on the London Stock Exchange. Schroder Investment Management North America Inc. is an indirect wholly owned subsidiary of Schroders plc and is a SEC registered investment adviser and registered in Canada in the capacity of Portfolio Manager with the Securities Commission in Alberta, British Columbia, Manitoba, Nova Scotia, Ontario, Quebec, and Saskatchewan providing asset management products and services to clients in Canada. Further information about Schroders can be found at www. Primer: the factor drivers of investment returns 1 schroders.com/us or www.schroders.com/ca.© Schroder Investment Management North America Inc. (212) 641-3800. FCTRPRMR2017