By Michael Fraikin
When an investment professional is asked to name the most influential concepts of recent years, factor-based investing is likely to rank high on the list. And when asked to name the most crisis-prone regions, they will probably think of Europe. Recent research suggests that these may be the ingredients for a perfect mix.
Quantitative investment strategies have become increasingly popular in recent years, particularly with institutional investors. For example, the U.S. market for “smart beta” ETFs, which incorporate factor-based investment strategies, has more than quadrupled over the past five years, growing from 63 billion to 257 billion US dollars.
The fundamental premise behind factor-based investing is relatively simple: by investing in stocks with certain characteristics – or factors – that have led to outperformance in the past, the thesis is that the index can be beaten in the future. Traditional factors include momentum (positive relative performance), value (comparatively attractive based on metrics such as book to price or price/earnings), quality (measures such as stable profitability, strong cash generation and less leverage) or volatility (typically assessed by using the fluctuation of stock prices).
New research by us suggests that it may be worth considering a quantitative, factor-based approach to investing in Europe in order to take advantage of elevated market inefficiency. At Invesco, we have been designing and implementing factor-based investment strategies for over 30 years and we recently examined the relative effectiveness of factor-based investing in Europe versus the world.
In our new paper titled: ‘The Case for Factor-Based Investing in European Equities (March, 2016)’, we examine data from the last decade which shows that while factor-based investment strategies have generally outperformed broad market indices over the long-term on a global basis, certain of these strategies (particularly those focusing on volatility and quality) have delivered even stronger returns when applied to European equities during periods of economic crisis. The question becomes: why? Is there something fundamentally different about investing in Europe compared with other regions, the Old World versus the New World?
As with all investment strategies, the factor concept only works provided it is not followed by too many investors and markets remain inefficient, at least to a certain point. If, for example, (1) value stocks are easy to identify and (2) everybody believes that they will outperform in the future, any advantage factor-based investing might have had in the past will quickly disappear. Perhaps this is why some indices based on commonly-used factors have been successful in backtests but proved less so in real life.
In response, investment managers have developed new and less well-known factors as well as investment strategies incorporating multi-factorial screens. The recent growth in factor-based investing is being driven in part by institutional investors recognizing that these strategies provide opportunities to take advantage of market inefficiencies created by, among other things, short-term market dislocation and irrational investor behaviour. The latest wave of economic, political and social turmoil in Europe, sparked by the refugee crisis and talk of a “Brexit,” among other factors, is producing just such an environment.
As noted above, the less efficient a market is, the greater the likelihood that a quantitative approach such as factor-based investing will have the potential to outperform. On the one hand, Europe is probably not the least efficient market in the world, but there is widespread consensus that it cannot match the US in terms of quick dissemination of information. This is mainly due to the higher trading volume of the US market, its larger capitalisation and its homogeneity.
On the other hand, Europe is probably less heterogeneous and complex than the emerging markets, which are widely (and rightly) considered to be the least efficient markets of all. This, in our view, makes Europe an attractive candidate for factor-based strategies – the market is inefficient enough to provide opportunities for quantitative managers and is at the same time homogeneous enough to be suitable for an investment approach focused on a limited number of factors.
Thus, while the current instability in Europe has caused some investors to stand on the side-lines, others are viewing it as a fresh opportunity to consider factor-based strategies. Given the recent track record for factor-based investing in Europe and the general trend in the markets towards such strategies, we are seeing renewed interest from our clients in them, particularly in the institutional space.
Michael Fraikin is head of research at Invesco Quantitative Strategies
