By Sasho Bogoevski
Financial markets are set to remain volatile amid diverging central bank policies and concerns about global growth, so investors could get caught out by crowded trades when sentiment changes.
Targeted investment strategies can help navigate such risk and capture opportunities that will perform in more volatile times.
Changes in sentiment, on top of the risk-on risk-of markets are exasperated today as Central Banks that have been following very unconventional monetary policies start diverging in how they deal with the challenges of anaemic growth. In this “risk-on/ risk-off” environment, investors are in danger of getting stuck with assets if everyone rushes to the door
Misunderstanding crowed trades: The concept of crowding can be easily misunderstood however it is critical for anyone that has around one year or less of an investment horizon for risk management. Some may mistake it for positive momentum because crowded stocks have tended to outperform recently.
And some may confuse it with growth, as crowded stocks often have higher valuations and expectations. We believe that some indicators can help avoid exposure to the so-called ‘winner’s curse’, when widely shared optimism about an investment’s desirability evaporates with its liquidity just when investors want out. These indicators are based on four factors that capture key aspects of crowding:
Breadth of Ownership: Widespread institutional adoption can leave few marginal buyers, so too many buy-side overweights are a telltale sign of crowding.
Consecutive Net Institutional Purchases: When significant purchases are observed over consecutive quarters, a crowd may be forming.
Volumes and Valuation: Watch out for irrational exuberance. Heightened trading volumes plus valuations above historical norms probably signal an overly excited market.
Sell-Side Popularity: Beware too many sell-side cheerleaders. Our research shows that stocks with the most analyst buy ratings underperform dramatically in the next 12 months. This further highlights the value of a well-researched contrarian view in an industry susceptible to ‘groupthink’.
There are several ways to mitigate crowding risks. These include: systematically resizing positions, continually taking profits on crowded positions, diversifying into uncrowded stocks, and selecting stocks according to specific factors that provide a balance.
Targeting factor opportunities: We regard targeted factor investing as particularly attractive because it offers a systematic way of providing balance in a portfolio by capturing risk premiums that should persist through market cycles.
While crowded trades often result from investors chasing broad stock characteristics—such as defensiveness, growth potential or sector exposure—factor investing, when done well, sidesteps the risks inherent in such an approach by focusing on specific risks that offer a differentiated pay-off.
As a result, portfolios can provide more balanced performance when uncertainties are rising. An equity factor portfolio can target exposure to characteristics, such as the expensiveness or otherwise of a security, how it’s trending and how much income it’s generating.
Such a portfolio can provide focused,cost-efficient access to specific exposures and to returns which, at market turning points, are less correlated to the broad market—and more dependable than those from a standard diversified portfolio.
The approach is very useful for managing risk and, according to our research, results in fewer unintended exposures.
One way to structure a global equity factor portfolio is to use regional building blocks. An appropriate approach today to Asia ex-Japan—given uncertainty about China’s growth and economic rebalancing—would be to target the factors of capital use and quality equally.
In Europe, where the outlook is coloured by deflation risk, the improving probability of credit growth and attractive value opportunities, an approach targeting 30% exposure to capital use, 30% to current value and 40% to deep value would be appropriate.
In the US, where economic recovery has narrowed valuation spreads and left few bargains, it would be appropriate to place a high focus—50%—on current value, 30% on quality and 20% on price momentum.
Given increasing divergence in economies and financial markets, it’s important that investors diversify their risk exposures. In our view, factor investing provides a disciplined and transparent way to do just that.
Sasho Bogoevski is managing director, Multi Asset Solutions at AB
