2021: Using factors to navigate challenging markets

Early 2020, equity markets were near all-time highs, oil prices were above USD 50 per barrel, volatility was low and credit markets were functioning well.

With the onset of the global Covid-19 pandemic, many countries took extreme measures, including locking down their economies to contain the spreading of the virus. A very sharp sell-off of global equity markets followed, only matched in terms of its scale and rapidity by that which preceded the Great Depression. In such circumstances, it would have been easy to lose conviction in the fundamental principles of investing. However, we believe these principles will survive this crisis, just as they have all previous ones.

From a high-level perspective, a systematic investment approach benefits from a strategic asset allocation aimed at harvesting a diversified set of asset class risk premia over the medium to long-term. Given the time-varying nature of risk premia, it makes sense to tactically deviate from a strategic positioning to better navigate periods of declining markets. However, not many (if any) tactical market timing models could have forecast the sharp sell-off in February and March, which emphasises the benefit of having a third line of defence in place, such as systematic risk overlays. These have been able to respond quickly to the challenging risk environment by reducing investment exposures in a timely manner and thus protecting clients’ assets. In the absence of an effective response to the Covid-19 pandemic, the associated uncertainties will continue to impact market returns, reinforcing the case for combining strategic and tactical allocation decisions with a prudent risk management overlay.

Focusing on equity investing, the year 2020 has been a tough one for value investors seeking to identify relatively inexpensive stocks based on companies’ fundamentals. The investment thesis underlying value investing remains intact, however, despite the value factor’s underperformance over a prolonged period. In addition to using an adequate and diversified definition of company value, capturing the associated premium will require investors to be patience, as markets need to regain confidence in the outlook for economic growth, and thus corporate earnings. Forecasting when this will happen is notoriously difficult, suggesting that a diversified approach which also capitalizes on momentum, quality or defensive stock characteristics would be beneficial.

As such, factor characteristics are not static for a given company but vary over time, therefore maintaining a balanced equity portfolio in terms of factor exposure favours a systematic approach. Specifically, systematic factor investing readily allows for tailoring the portfolio’s characteristics to meet the specific investor’s needs, such as implementing an explicit defensive tilt to improve a portfolio’s resilience in times of turmoil.

A systematic approach to investing is also well suited to cater for an investor’s desire to improve a portfolio’s sustainability profile. We expect the importance of sustainability in investment processes to rise among investors and regulators, and tailored systematic investment propositions allow investors to meet their sustainability objectives without sacrificing factor exposures and their associated return benefits.

With factor investing becoming an established investment paradigm, the number of available factors will continue to rise at a fast pace. This proliferation of the factor zoo reinforces the need for a rigorous research protocol to help identifying genuinely attractive investment factors. Whilst the emergence of alternative data and machine learning increases the need for rigorous research, it broadens the opportunity set for quantitative asset managers in tapping new sources of value-add for improving their investment processes and addressing specific client needs. A promising route in this regard is the application of natural language processing (NLP) techniques to unearth predictive signals by systematically analysing news data or corporate disclosures, such as earnings call transcripts. Having machines read the news enables innovative investment themes to be tracked efficiently, as well as companies to be identified that are associated with those themes and are expected to benefit from the associated growth potential.

An investment proposition leveraging such methodology could aim at providing diversified exposure to themes associated to key mega trends such as technological innovation, demographics and society, as well as, environment and resource scarcity. Naturally, the themes associated with environment and resource scarcity are of major importance in curbing the adverse impact of climate change and such investment technology can shape investment propositions focused on investing in companies that contribute positively to a transition to a low carbon economy, or are developing solutions which enable the transition of the economy.

In summary, despite the prevailing issues challenging market participants, a systematic investment approach leverages a tested toolkit to navigate these challenges and adapt to the opportunities in markets.

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