Diversification is key to managing risk in a portfolio, be it the credit risk of investments held for liquidity purposes or the market risk associated with holding longer-term strategic funds to generate income. Maintaining a diversified portfolio of longer-term investments typically means holding a range of asset classes with the aim of gains and losses in one offsetting gains of losses in others to reduce volatility at the portfolio level, while still generating income and capital growth.
However, with central bank quantitative easing programmes over the last decade or so, and more recently a pandemic, pushing the returns of some asset classes to move more closely in step with each other, this has reduced the diversification offered by, say bonds and equities, making traditional strategic asset allocation decisions even more difficult.
Despite the multiplicity of asset classes and individual securities, academic research has shown there to be a smaller range of ‘factors’ which drive returns across asset classes and may help investors when choosing between asset classes or pooled funds.
There are two main factors which drive returns, macroeconomic factors, and style factors. Macroeconomic factors such as economic growth, inflation, credit, and real interest rates can help explain returns across asset classes, while style factors such as value, size, quality, and momentum can help explain returns within asset classes. Using these factors to make investment decisions is not a necessarily replacement for more traditional asset allocation choices but can certainly be used to complement some of the wider elements of asset selection.
For equity investors, selecting a fund comprised of large, mature companies could generate the returns desired, however, research on the ‘size’ factor shows small companies can outperform larger companies over the medium to longer-term (known as the ‘small cap effect’), including offering potential higher levels of dividend growth in what is often a much less research area of the market compared to large capitalisation companies. The performance of many very large companies tends to be aligned with the health of the global economy, while smaller companies are typically more correlated with the strength of their home economy, meaning an equity allocation using both large and smaller companies can improve diversification as well as potentially boosting future returns.
The ‘value’ factor is probably the most well-known, based on the style of choosing under-valued (i.e. ‘cheap’) companies and waiting for the price to rise. The strategy is driven by the perception that financial markets can overreact to a temporary weakness in company fundamentals, pushing share prices down to levels not representative of underlying earnings. Having bought the ‘cheap’ shares, the value investor then waits patiently for financials markets come back into line with their view and the share price rises back in line with the company’s underlying prospects and earnings. Unfortunately, this may take a while, or the decline in price could indeed reflect a long-term deterioration in the company. Such issues have helped fuel the ongoing debate around growth versus value stocks, but as value stocks tend to be large, stable, dividend paying companies the style remains popular among investors, particularly those focused on income generation.
‘Quality’ aims to identify companies with durable business models, and which often have competitive advantage in their sector. The financial measures/ratios used by investors to identify suitable companies include return on equity, debt to equity, and earnings variability. Companies using investments to generate stable earnings growth and low levels of debt (leverage) are deemed to be ‘defensive’ in nature, meaning these companies continue to perform well in an economic downturn, something which would have been welcomed by many investors in 2020.
The last of the factors identified above, ‘momentum’, is based on investing in companies whose share price has performed strongly in the past in the belief this performance will persist, at least in the near-term. This strategy is typically more short-term in nature and is based more on the movement of a company’s share price rather than an assessment of its fundamental value, making it less suitable for many long-term investors. Associated more with growth investing, it is this type of strategy that has helped some US technology stocks reach stratospheric prices compared to their underlying earnings.
By considering some of these factors will not necessarily of themselves guarantee strong future returns but bringing them into the mix may help with asset allocation decisions and potentially a wider range of investments that had been thought about previously. As ever, please get in touch by emailing treasury@arlingclose.com for any investment assistance required.