Over the last few years, many financial services companies have been issuing new investment vehicles meant to take advantage of equity ‘factors’ (sources of incremental return above and beyond the general equity market). These products, sometimes referred to as ‘smart-beta’, try to provide investors with exposure to one or more of the proven factors that have historically lead to portfolio outperformance including momentum, size, low beta/low volatility, quality, and value. While a static and broad factor-sensitive portfolio can add to returns over time, further excess returns may be possible by taking a tactical approach to equity factor investing. Often, movement into and out of factors is rather subdued as investment cycles can be rather long relative to sector rotation. There are, however, some economic turning points or events which provide an impetus to examine and evaluate the feasibility of factor allocations. While the recent election of Donald Trump as the next President of the United States has caused a revaluation of investment interest in different sectors and industries, I think it is also necessary for factor investors to reconsider their positions. With that in mind, let’s consider the factor exposures mentioned above.
First, factor investors can’t be blamed for avoiding the momentum factor for the time being. Momentum works well when the stocks that have recently outperformed continue to outperform. Given the monumental policy shifts that may take place under a Trump presidency, outperformance by last year’s stock market darlings is not likely to persist.
While momentum appears to be obviously out of favor, the size factor seems to be clearly in favor as investors consider whether President-elect Trump will follow through on his plans to renegotiate foreign trade pacts and impose tariffs. Smaller companies are generally more tied to domestic consumption as opposed to reliance upon foreign trade. If free trade is hindered, larger multi-national stocks will likely suffer more than smaller domestic-focused ones. This opinion appears to be somewhat wide-spread as the Russell 2000, which includes smaller stocks, has risen around 10% since the election whereas the S&P 500 is up 2%. Will small caps continue to outperform relative to large caps? That will hinge on a number of things, including whether the perception regarding the incoming administration’s trade policies turns out to be justified.
Low beta/low volatility is a defensive factor that could be desirable at this late stage in the economic cycle. Unfortunately, this factor attracted a great deal of investor attention within the last year as market participants have sought equity exposure with less risk. The result is that getting pure low beta or low volatility exposure is now fairly expensive and may come with the added risk of being overweight interest-rate-sensitive sectors like utilities.
Quality is also a defensive factor but, unlike low beta and low volatility holdings, quality stocks are currently priced in line with broad market multiples. Quality companies are those with strong profitability, low leverage, highly visible earnings, and strong management. The risk of owning quality is that these holdings will often lag when a high growth economic environment enables a broad-based market rally. This is an interesting possibility which I’ll address alongside our final factor…
Financial academics argue as to whether the value factor stems mainly from investor behavioral errors, or from the higher systematic risk associated with value holdings. If we accept that both of these explanations have some validity, then that means that some value stocks trade at lower earnings multiples in order to compensate investors for excess risk. Put another way, some value stocks are cheap for a reason. These stocks benefit most from a generally stimulative economic climate – a “high tide that raises all boats” – which many market onlookers envision resulting from Trump’s pro-growth policies. Note that this is precisely the sort of environment in which quality stocks lag. To be clear, the quality and value factors are not necessarily opposites, but I have framed them in this way to help consider their distinct merits.
Should investors seek exposure to quality or to value? On the one hand, we are very late in the economic cycle, there is the possibility of geo-political shocks as several European countries have upcoming elections, interest rates are heading up, and there is the potential for trade wars. On the other hand, Trump’s economic agenda centers around deregulation, corporate and individual tax reform/reduction, and a large infrastructure spending plan. Will the tide come in and enable a broad rally in which value stocks outperform? Or will the tide go out, enabling only the stronger quality stocks to outperform? As with the consideration of the size factor, much will depend upon how effective Trump is in carrying out his policy proposals.
Political opinions will obviously differ with respect to how capable Trump is likely to be, what agenda items he is likely to prioritize and pursue, and to what extent Congressional Democrats (and some Republicans for that matter) will work with him. Additionally, we must remember that while politics is currently in the spotlight, many other issues (including movement in interest rate and currency markets) will be instrumental in determining which factor exposures will be most advantageous for the foreseeable future.
Ultimately, we have no crystal ball that can give us the answers, but there are two general statements that can help guide investors. First, different investors may come to opposite allocation decisions not because of distinct views on likely political outcomes, but based upon their differing risk tolerances. For instance, an aggressive investor that consistently seeks higher risk factor exposures will feel comfortable with a higher risk portfolio tilted towards small cap and value stocks; a more conservative investor that consistently allocates toward defensive factors may prefer a quality large cap portfolio. Second, factor allocations do not need to be all or none decisions. A diversified equity portfolio that tilts slightly toward size, quality and value exposures will provide broader coverage with the possibility for outperformance.
Have questions about equity factors? Send me an e-mail at andrew@lpastrategic.com.