Trumponomics has taken its toll on factors

DOOR JAN JAAP OMVLEE

Is factor investing the new battleground of the active versus passive debate? We asked Thomas Kieselstein, Co-Founder and Chief Investment Officer of Quoniam Asset Management. Consider ESG as an important aspect, but it is a different type of factor.

Part of the reasoning behind factor investing allocation has to do with the availability of supporting scientific research and with the high cost pressure in investing in general. Investors are looking to reduce their overall cost and to allocate to semi-active strategies or something in between active and passive. This means that essentially much money is going to semi-active or semi-passive investing.

What types of strategy do we have?

‘There are three types of strategy involved here; one is traditional active management, the other is pure passive in the sense of market cap and then there’s factor investing. Within factor investing we have more passive approaches and more active approaches, hence the name ‘new battleground’.

Basically, we have to differentiate between two reasons. The first is that there is some form of additonal risk: the ‘factor risk premium’. This type of risk may include higher business risks. For example, value stocks tend to be more cyclical in nature, but there may also be technical or implementation risks involved, for instance low liquidity in small-cap stocks. Of course, the additional risk premia does not always pay off; it pays off over the long cycle, but not necessarily in every year.’

What is the other reason?

‘The other key reason why it makes sense, is more efficient information discovery. So the fact that you systematically use data to cover large universes of stocks, may enable you to detect opportunities which traditional investment managers with less technology or less data available are not able to detect.’

Is there such a thing as a preference for certain factors?

‘At Quoniam we do have a certain preference for the information discovery as opposed to the risk premia part of factor investing. Simply because risk premia may be a little less effective going forward due to the fact that many investors are already doing this and it’s a relatively easy task to do – which could make this a crowded space. There is a counter argument that every ten years it may fail miserably and then the crowd leaves again.

Figure 1: Relative performance anti-benchmark versus benchmark

Relative performance anti-benchmark vs benchmark

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Source: Quoniam Asset Management GmbH. Compares a 3-Factor (Value, Quality, Sentiment) strategy in two implementations. Universe: Global developed markets 30/06/1995 – 30/09/2019.

Figure 2: Large US Technology Equities strongly outperformed

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There is a difference between simple and advanced factors and you should know about this.

Consider ESG as an important aspect, but it is a different type of factor that should be used in a holistic context rather than a risk-return context.

What happens on the more advanced information discovery part is that, instead of simply screening for some very simplistic value ratio’s, you would do more in-depth analyses, for instance collecting off balance sheet data to capture value, such as brand value or intellectual property value. This is more difficult to do and of course not easily repeatable.’

Could you elaborate on combining the factors?

‘Obviously, there are different schools and opinions on how to combine factors. Simplistically put, one uses top-down thinking and combines several single factor managers or portfolios. A different school looks at the data bottom-up and combines multiple factors on a single stock level. Now each of the two schools has its merits.

Empirically, it can be shown that multi-factor stock selection is more efficient in the long term, especially for more active portfolios and the more factors you include. The top down single factor can be better in extreme situations. So if you have a junk rally for example, then the one value portfolio is so good that it beats the stock selection portfolio.’

What are other differences?

‘The other difference is that if you have a strong opinion on one factor, then a factor timing may be easier to implement in the top-down approach, simply by deallocating money from one portfolio to another. However, our opinion would be that on average factor timing does not make sense, because it is costly due to higher transaction costs and the need to physically turn over entire portfolios. Even market timing, which is less costly, has a very mixed track record.’

So what are the differences between ‘active’ and ‘passive’ factor investing?

‘In summary, there are three aspects: one is simple ‘risk premia’ factors versus more advanced ‘information discovery’ factor definitions, the second aspect is how you combine factors as described earlier and the third one being how you determine the weights in the portfolio. For the third dimension, we can differentiate between a version where you depart from market-cap, and position yourself over- or underweighting relative to a benchmark. The other one builds an anti-benchmark portfolio bottom-up and is typically underweight in large-cap stocks.

We have tested the same factor signal, once constructed as an ‘anti-benchmark’ portfolio and once as a ‘benchmarkrelative’ version. Figure 1 shows the performance of the ‘antibenchmark’ relative to the ‘benchmark-relative’. At the end of the 1990s, we saw the ‘anti-benchmark’ underperform due to the tech bubble. After the tech bubble we can witness an outperformance. In recent years, especially in the last two years, we’ve seen again a strong underperformance of the anti-benchmark, again due to a strong performance of largecap technology stocks.’

Photos: Ruben Eshuis Photography

CV

Thomas Kieselstein, CFA, is Co-Founder and Chief Investment Officer of Quoniam Asset Management. As CIO, he oversees Quoniam’s Equity, Fixed Income and Multi-Asset investment teams. Prior to Quoniam, Kieselstein worked for DZ Bank and Dresdner Bank Investment Group. He has been developing quantitative investment processes for multi-factor strategies since 1994.

The choice between single-factor versus multi-factor depends on your governance. If you are a topdown allocator, you may want to use single factors. If you are looking for the most efficient form of factor investing, then use a multi-factor investment process.

What does this mean for investors?

‘Although on average the anti-benchmark is more efficient, there can be prolonged periods of very strong performance of large-cap stocks, and the advantage realises only in the long term. For investors concerned about such tracking error, a benchmark-relative version can be more appropriate.’

How can we summarise this?

‘Some factor investing strategies have underperformed quite substantially due to two reasons. The first is the huge outperformance of large cap technology, the second is the strong underperformance of the value factor. Apart from its obvious underweight in technology, this is also due to concerns about the global trade war. Value portfolios tend to be invested in manufacturing and are hence sensitive to global supply chains and exports being curbed. By contrast, quality portfolios are currently overweight again in technology and staples - so Trumponomics has had a huge effect on factors.

This is the risk part of investing. That’s why there is a premium in the end. Now we had a political and macroeconomic environment which was especially unfavourable to value and mid-cap stocks.’

How does the ESG factor relate to factor investing?

‘There is a debate going on about whether ESG is a factor like other factors. Some say it is a factor because you can measure it. We have the data to at least partially measure ESG, but it is very complicated because there is not one number out there. There are many and they are not all the same. The correlation matrix of all different types of ESG data shows that, when we talk about the same category of overall ESG ratings, there are many different data available, with many different providers having low correlation.

Data providers do lots of data tweaking before they put their lists together, while data are more standardised in the environmental space. The method for determining the carbon intensity of a portfolio is largely similar, so there is much more similarity there between different data providers.’

The question remains: is ESG a factor?

‘Yes, because we can measure it. But it does not fall into the general categorisation of factors, since it is unclear why there should be a premium for it return-wise; there is no additional risk involved. By contrast you may use it to reduce risk, so there may be a long-term risk to society or the environment, but that would mean you earn a lower premium. So is ESG a risk premium? Probably not.

Then there is this information discovery aspect. Is it possible to select better stocks with it as for the information discovery of factor investing? This might be true, but it is hard to prove. And why should you use ESG data to select those companies? Isn’t it easier to use other factors to analyse this? There is much interest in ESG, so there is a demand. It may well be that you have an outperformance temporarily because of that demand effect.

Taking this together, we argue that you should look at ESG not so much from a financial point of view, but from a holistic one. ESG should therefore not be bought only for risk-return reasons.’«

About Quoniam

Quoniam Asset Management GmbH (‘Quoniam’), founded in 1999, is a pioneer in quantitative asset management and invests in public equity, fixed income, and multi asset markets across the globe. Quoniam is using a scientific approach to investing called ‘quantitative investment engineering’. This is a transparent, high-tech investment process, which analyses particular factors that are both economically plausible and empirically verifiable. Using this expertise, Quoniam, with offices in Frankfurt and London, is managing €31 billion in assets for global investors. www.quoniam.com