Stable and attractive Returns are achievable with a sophisticated factor investing Source: istockphoto / Eltoddo

Factor return with flexible risik budgets

Author: Dr. Markus Brechtmann, Senior Portfoliomanager Universal-Investment

The UI-Factor-Return approach is a new addition to Universal-investment’s rule-based product offering. Dr Markus Brechtmann, senior portfolio manager quantitative portfolio management, explains how the exploitation of various factor risks can yield returns in all market environments.

Dr. Markus Brechtmann, Senior Portfoliomanager Universal-Investment Source: Universal-Invesment

“Factor investing” has long been part and parcel of Universal-Investment‘s bottom-up skills in quantitative portfolio management. Value, momentum, low, risk and size strategies have been extensively analysed in empirical capital market research and implemented by Universal-Investment as factor, risk premium or smart beta strategies in customised strategy portfolios. The new UI-Factor-Return product now extends the factor risk approach from the bottom-up to the top-down level enabling portfolio managers to assess the attractiveness of the equity market as a whole and manage portfolios based on a total return target. The quantitative analysis of different sectors generates signals - transparently and based on strict rules. The equity exposure is then determined on a monthly basis depending on various factors situations. This approach enables Universal-Investment to generate attractive returns even though it is impossible to forecast stock market developments with absolute certainty.

Top-down factor analysis drives equity allocation

The beauty of the approach: the questions based on which we develop our expectations for the development of various stock markets over the next four weeks each month take both technical and fundamental, macroeconomic and sentiment factors into account. The systematic analysis of these indicators never loses sight of the economic aspect, because we take equity risk under the factor return approach if the following factor characteristics are present:

  • The stock market is attractively valued
  • Earnings grow and revisions are to the upside
  • Leading macroeconomic indicators rise
  • Sentiment for risk assets is positive
  • The stock market is trending upwards

The more factors speak in favour of equity investments the higher the equity exposure. Our metric is the stock market gauge that aggregates the analysis of all indicators into a value between -2 and +2. At 0, positive and negative signals are equally distributed; a positive value indicates that a majority of factors signal a rising market whereas a negative value suggests a falling market. The monthly development of the stock market gauge for the Euro Stoxx 50 is shown in the following chart.

Zoom
Zoom

The stock market gauge enables us to transparently and concisely pinpoint market sentiment with only one number. It provides signals for the tactical asset allocation (TAA) across the different stock market segments. We implement the TAA signal in a cost efficient manner via DAX, Euro Stoxx 50 and S&P 500 futures. The overall equity allocation depends on three components: the investor’s risk capacity, the market view – as measured by the stock market gauge – and the current stock market volatility.

Total return through risk-adjusted investing

The defensive variant has a lower risk budget, so that its historic volatility is below the volatility of an investment in German government bonds. The risk of the balanced variant (“Balance”) is more or less in line with a bond investment whereas the aggressive variant (“Opportunity”) has been designed to achieve the return of equity investments over time – however at a lower risk and lower drawdowns.

Risk budgets of the three variants

The table below shows the risk budgets of the three variants of the UI strategy whose respective equity exposures result from the relationship of these risk budgets with market volatility. In the “Balance” variant, for instance, the risk budget is three percent if the stock market gauge is neutral (0). If stock market volatility is 15 percent, the corresponding equity exposure is 20 percent. The logic is simple: The exposure will fall as market volatility rises and increase as market volatility declines. The following chart, which depicts the performance of three Euroland variants (see below, right hand side), shows how well this approach would have worked in the past. All three variants achieved stable and positive returns over the period under review. While there is a positive correlation to the stock market, it is low, and the maximum drawdown in all three variants was significantly below that of a long-only equity investment.

Zoom

Attractive risk/return profile

Thanks to the diversified mix of market and factor risks, all three variants of the UI-Factor-Return product achieved an extremely attractive risk/return profile with a Sharpe ratio of 0.75. The concept offers investors the opportunity to participate in various equity risk premiums, which leads to an equity-based investment with total return characteristics that can still generate adequate returns in low interest rate environments. 

Author: Dr. Markus Brechtmann, Senior Portfoliomanager Universal-Investment
Date of issue: 3/1/2017