August 2022 – ISSUE 7
Why ‘factors’ are factored into qualitative investments.
In quantitative equity investing there is always talk about factors, but what is a factor, how are they defined, and does the Australian equity market have any that stand out?
Investors have long used general rules to think about investing.
Knowing that one group of stocks has more potential than another group can help investors focus their research. We can think about these groups of stocks in the following way:
When thinking of factors, it is always important that investors take a long term view. No strategy will outperform all of the time. So investors need to be aware that all of these individual factors will experience periods of under-performance.
Some factors are commonly used by practitioners all over the world, often because they have been examined in detail by academics. Of course, it is possible to construct a factor portfolio with any metric an investor would like. But having said that, it’s always worth paying attention to the most commonly used factors, if only because they are the focus of such a large number of investors.
The following factors are commonly used and referred to by fund managers, which are based upon empirical evidence and abundant academic research. However actual definitions can differ depending on the asset manager.
Momentum – Stocks with strong recent performance tend to outperform those that have had recent poor performance.
Low Volatility – Stocks with lower volatility outperform stocks with higher volatility.
Value – Cheap stocks should do better than expensive stocks over the long run.
Size – Small stocks outperform larger ones over time. As smaller businesses generally have the capability to grow faster than larger ones.
Quality – Companies that generate high returns on equity outperform those that generate lower returns from the same equity.
Growth – in some instances this is treated as the opposite of value. Here at Platypus Asset Management, we use improvement in next 12 months estimated earnings growth.
Quantitative factor investing takes one or more of these factors and applies rules to them to construct portfolios. For example, if an investor believes that cheap stocks will do better than expensive stocks over the long run, the investor can implement this with a quantitative factor portfolio of stocks that have P/E ratios below a certain value. To ensure the portfolio keeps holding the cheapest stocks in the market, the portfolio would be regularly rebalanced. This would be referred to as a value factor portfolio.
Do any particular factors stand out in Australia?
Factors perform differently in different markets so it makes sense that the way factors perform in Australia will be different to the way the same factors perform in global equities. This highlights the importance of local expertise. Australian factor portfolios should be constructed by those with experience investing in Australian quantitative strategies.
We construct simulated portfolios using Platypus Asset Management’s in-house Australian equities database. To construct the factor portfolios, we order by the factor measurement, and then take the best 20% to form a basket of stocks. We assign the same weight to each stock in the basket. Every month, we re-balance the portfolio to make sure that we always own the best 20%.
For momentum this means the top 20% best performing stocks over the past 12 months, and for value this means buying the cheapest 20% of stocks at that moment in time. We do not take account of costs or market impact with our simulations.
The chart below shows the remarkable performance of Momentum in Australian equities. After investing $1 in June 1992, the investor has $153.82 by March 2022. This return is 10 times greater than the Australian market, with the S&P/ ASX 300 returning investors just $15.04 in comparison. Value, on the other hand, has underperformed. It has returned investors just $5.57 over the same period.
What does this all mean?
One thing for investors to consider is how this helps them understand the active managers in their portfolios. Put simply: how much of the returns of their active managers are because of the factor bets that the manager is making?
If it is a large amount, then perhaps an investor is better off switching to a cheaper, quantitative factor based portfolio, one specifically designed for the local market.
The before fee returns they achieve might be similar, but the after fee returns will be more compelling. After all, no one wants to pay for something they do not receive.
We will go into more detail in future Hatchings about how investors might achieve this, and how active managers in Australia can be compared using factor portfolios.
‘Perhaps an investor is better off switching to a cheaper, quantitative factor-based portfolio, one specifically designed for the local market’
Disclaimer: Issued by Platypus Asset Management Pty Ltd ABN 33 118 016 087, AFSL 301294 (PAM). This material provides general information only and does not take into account your individual objectives, financial situation, needs or circumstances. Prior to investing in any financial product, an investor should determine, based on its own independent review and such professional advice as it deems appropriate, the nature and extent of economic risks and merits, the legal, tax accounting characteristics and risk, and the consequences of an investment in the financial product. This material is not a financial product recommendation or an offer or solicitation with respect to the purchase or sale of any financial product. While every care has been taken in the preparation of this material, no warranty of accuracy or reliability is given and no responsibility for the information is accepted by PAM, its officers, employees or agents. PAM is part of the Australian Unity Group of companies.