Bottom-up factor investing is based on the theory that investors in equities can not only collect the general risk premium of the stock market, but several different risk premiums. Which and how many risk factors there are – and how high their premiums turn out to be – has been the subject of debate in empirical capital market research for more than 50 years. However, there is consensus on the point that there are several risk factors – and therefore risk premiums. Factor investing is the general term for any strategies that were conceived to tap these additional sources of return. The four most well-known factors include:
GARP stands for “growth at a reasonable price.” This combines two factor approaches that are actually conflicting: the value approach, which focuses only on attractively priced equities, and the growth approach, which concentrates exclusively on future profit potential.
The pricing process in the capital markets is controversial. Proponents of the efficient-market hypothesis believe that new information is evaluated simultaneously by all market participants and is processed immediately, completely and accurately into market prices. However, recent research findings from the field of behavioural finance underpin the explanatory approach, which holds that new information is processed only gradually and expectations are formed continuously. The result of this theory is the emergence of trends in relation to individual equities that the momentum strategy focuses on.
One factor-based strategy that has become very popular with institutional investors is based on the low-risk approach. The focus is on equities with low risk indicators, such as volatility and the beta factor, because research has proven that these low-risk equities perform far better than would be expected based on the capital asset pricing model. For this reason, the long-term risk-adjusted performance of low-risk strategies is more attractive to many investors than investing in equity indices weighted by market value.
It is generally known that dividends contribute significantly to the performance of equity markets. In a low interest-rate environment, in particular, the dividend approach is therefore attractive to investors because it is limited to equities with high dividend yields, strong historical dividend growth and good prospects for future dividend payments and increases.
Besides the four factors outlined above, the size of a company is also an important individual factor. The size or small-cap effect shows that the shares of low-capitalised companies perform better than the overall market because investors are rewarded with risk premiums in the long term for accepting lower levels of liquidity. Indeed, Universal-Investment explicitly offers a small-cap product, but the size factor is an implicit feature of all UI single-factor strategies because all securities of an investment universe are weighted equally in the portfolio construction. Smaller securities are therefore weighted much higher – and larger securities much lower – than in comparable portfolios with weightings based on market value.
Investors should focus on a combination of several factor portfolios in which the relevant factors are reflected in an isolated, aggressive and pure way through rules-based, transparent investment processes. In combination, the result is a balanced and well-diversified equities portfolio. For the implementation, we prefer long-only strategies because we control the general market risk with our top-down factor approach. Long/short factor strategies are also difficult to implement and carry higher risks on the short side.
The equities universe of the Euro Stoxx 50 is one example of how well the bottom-up factor approach works. This small and liquid universe was specifically chosen to make it clear that all the listed factor premiums are also clearly demonstrable in a blue-chip segment. Factor investing can therefore be implemented even with small investment volumes. With larger investment volumes, a broader equities universe makes sense as a basis.
As the illustration of absolute performance shows, all four mentioned factor strategies easily outperformed the cap-weighted Euro Stoxx 50 over the long term. This also applies to the factor composite consisting of the four equally weighted factor strategies. However, the course of its outperformance is more continuous than with the single-factor strategies.
A glance at the relative performance of the factor strategies shows why one should employ several risk premiums at the same time. Since the factors tap different equity segments, the correlations between the active factor returns tend to be low, so the diversification effect between the risk premiums turns out to be particularly high.
With the bottom-up factor portfolios and the factor composite, a higher return can indeed be achieved – and with less risk – than with a corresponding, cap-weighted benchmark index.
Besides the bottom-up factors outlined here, there is also a top-down approach, which was presented in the last edition of allocate! (No. 15, Spring 2017). The following illustration shows how these investment processes are combined: Combining top-down management of investment levels with bottom-up factor investing constitutes the innovative UI Factor-Return approach. Through individual risk management, the risk expectations of each investor can be considered flexibly. In order to cover the entire range of risk appetites, we offer the UI Factor-Return approach in three versions: opportunity, balance and defensive.
Author: Dr. Markus Brechtmann, Universal-Investment
Date of issue: 10/30/2017
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