From Volatility to Value: What the Factor Shift Means for Smart Beta Investing


From a factor perspective, global equity markets have made a big change in recent months from a risk-off defensive posture to a risk-on growth orientation. During this time, low volatility stocks have struggled, while value stocks have rallied sharply. For smart beta investors, these shifts underscore the benefits of multi-factor strategies that can help to mitigate the cyclical changes in factor performance. 


Value and volatility: Trading places in factor leadership


We’ve seen evidence of this equity market shift from a risk-off defensive posture to an offensive risk-on orientation in the MSCI World Index. The index has witnessed a widening positive spread between the rolling six-month returns of the highest and lowest beta stocks.1 

The valuation of the low volatility factor was extremely expensive going into the third quarter of 2016, but this dramatic dislocation has brought this measure back to its 10-year average, as shown in the chart below. Here, we are comparing the difference, or spread, between the median book–to–price of the highest ranked stocks of the value and low volatility factors and the lowest ranked stocks of those particular factors. When the spread is wide, that factor is attractive based on valuation and the opposite when the spread is narrow.
 
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Source: State Street Global Advisors, MSCI, as of 1/1/1987-12/31/2016
Past performance is not a guarantee of future results.

While low volatility has been left behind, the value factor has been a standout. The shift toward value really picked up steam after the US presidential election because of the expectation of renewed growth and that cheaper valuations would be realized. Also, the value factor’s effectiveness seems to be highly correlated with the potential for rising interest rates and inflation, tighter US Federal Reserve policy and widespread deregulation.

From a short-term perspective, the value factor has flipped toward more expensive territory. Although the factor is now trading at above-average valuations, seven straight years of underperformance suggest that we may be only in the beginning stages of the factor’s turnaround.

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Source: MSCI, Bloomberg Finance L.P., as of 12/31/2016
Past performance is not a guarantee of future results. Index returns reflect capital gains and losses, income, and the reinvestment of dividends.
Difference in the performance of the MSCI World Value Total Return Net Index and the MSCI World Total Return Net Index. 


Assessing fundamental value


Strength in value could be a positive sign for equity investors, suggesting we might be getting back to stock fundamentals. With growth prospects brightening and interest rates likely to trend higher, we believe relative valuation will matter more. We see the opportunity for well-managed companies to enhance their earnings, return on capital and book value. 

But in our view, whether the value factor’s run can persist depends on the direction of interest rates:
 
  • If economic growth takes off, and the normalization of interest rates and the yield curve continues as we move to the next phase of the economic cycle, we anticipate that fundamental value strategies could do well.
  • If markets become less confident that reflation and deregulation will materialize and new trade barriers will create problems, then we would expect the antithesis of value—low volatility—to have better performance.

No matter how the equity market moves from here, we believe one thing is certain: The market will not go in a straight line. Factor returns have tended to be sudden and lumpy in nature. That is why our fundamental value strategies aim to stay invested throughout the cycle so we can participate when the rallies occur.


Benefiting from multi-factor investing 


Early adopters of smart beta strategies have tended to emphasize single factors, with low volatility and high dividend strategies in particular experiencing strong inflows. Yet, rapid and unanticipated macro movements can be difficult to time with a single-factor focus.2 These shifts underscore the benefits of taking a multi-factor investing approach to mitigate the cyclical changes in factor performance. By utilizing a multi-factor smart beta strategy, investors may be able to take advantage of the diversification across factors over time. That multi-factor advantage could become more valuable both in managing risk in the erratic market environment that we anticipate in the near term and driving returns.

To learn more about smart beta and multi-factor investing, you can read some of our earlier blogs: 


1Beta measures the volatility of a security or portfolio in relation to the market. MSCI World Index is a free-float weighted equity index including about 1,600 stocks from developed world markets.
2On top of 2016’s twists in price momentum and value around Brexit and Trump, as well as the pullback from equity dividends on the expectation of rising bond yields, factors experienced another rotation this past January, with momentum on a tear while quality stayed in place and value, high yield and low volatility all lagged.

Definitions

Book Value
The net asset value of a company, calculated by total assets minus intangible assets (patents, goodwill) and liabilities.

MSCI World Index
A free-float weighted equity index. MXWO includes developed world markets, and does not include emerging markets. MXWD includes both emerging and developed markets.

MSCI World Value Index
The MSCI World Value Index captures large and mid cap securities exhibiting overall value style characteristics across 23 Developed Markets (DM) countries. 

Price-To-Book Ratio
A valuation metric that compares a company's current share price against its book value, or the value of all its assets minus intangible assets and liabilities. The P/B is a ratio of investor sentiment on the value of a stock to its actual value according to the Generally Accepted Accounting Principles (GAAP). 

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