*This article is produced in partnership with iShares by BlackRock and MSCI.
Market events so far in 2024 have served as a reminder that the global economy may not be “out of the woods” yet when it comes to persistently high interest rates and uncertain growth. Recent CPI data out of Australia and the US has surprised on the upside, while the escalation of tensions between Israel and Iran has markets nervy about a potential future energy shock.
With macro risks abounding in today’s volatile environment, it’s important for investors to be “the pilot not the passenger” and take a selective approach to allocations. This is where factor investing can help, by enabling investors to focus on the long-term drivers of excess returns in equity markets, and providing additional diversification to help portfolios weather the storm of market volatility.
What is factor investing?
Factor investing is the strategy of identifying stocks within an investment universe that exhibit certain characteristics, or factors. These factors can help investors to drive stronger long-term returns, lower the overall level of risk in a portfolio, or tactically zero in on types of stocks that may outperform in different market conditions.
Factors like quality, momentum, value, minimum volatility and size have been a significant part of active managers’ investing toolkit for many years, having first been discovered by Columbia accounting professors Benjamin Graham and David Dodd in the 1930s. They are supported by decades of economic theory, including six Nobel prizes.
Factor strategies – A deeper dive
Investment managers may assess each of these factors in different ways, so it’s important to define our approach to factor investing.
In terms of quality, BlackRock looks at profitability, leverage and earnings stability to determine if a company meets the definition of a quality stock. When it comes to momentum, we measure upward price trends on both a six-month and twelve-month basis. For value, we look at financial ratios including price-to-book, forward price-to-earnings and enterprise value to cash flow from operations to assess if a company may be undervalued. And when evaluating minimum volatility, we look at both individual volatility and how stocks move relative to each other.
Whether used individually or in combination, these factor strategies can help to diversify portfolios, add resilience in the face of challenging market conditions, and help dial in an investment portfolio to some of the key drivers of long-term outperformance.
Mark Carver, global head of equity factor products at MSCI, says factors can be used effectively in three ways – for very strategic, long-term consideration to complement your portfolio for diversification; for risk hedging; or for a tactical approach to try to capture opportunities in the near term.
“It’s important for investors to use a factor lens in portfolio construction to enhance resilience,” Carver says. “Leveraging factor insights is key to optimising portfolios and ensuring alignment with investment goals.”
The long-term performance benefits of factors are well-known – if we look at the performance of global equities exposures focusing on each of the three factors, they have all comfortably outperformed the broad market index on a cumulative return basis over the past 25 years.[1]
On a short-term basis, factors tend to be cyclical in nature, so can outperform based on the macroeconomic conditions of the day. During periods of economic recovery, value stocks tend to do well. When the economy moves from a recovery phase to a more mature expansionary period, momentum stocks may generally outperform.
When the economy slows or contracts – such as in the current inflationary environment, where central bank authorities have sought to put a handbrake on economic activity through interest rates – quality stocks will often perform strongly. As a result, global investor funds have overwhelmingly flowed towards the quality factor so far this year, with iShares quality ETFs receiving over US$11.5 billion ($17.24 billion) of inflows in the year to date.[2]
Why factor ETFs?
Accessing factor strategies in an ETF format means investors have more choice around how they construct their portfolio, and potentially a better toolkit to navigate changing market conditions. The liquidity and cost-efficiency of ETFs means that each factor strategy can be easily added to client portfolios as a strategic tilt, long-term building block or complement to existing active or passive investments.
If we take the MSCI World Australia index as an example, we see a more than 40 per cent exposure to value stocks, so it’s likely that if an investor has a portfolio that is chiefly made up of broad Aussie equities, they may have an overweight to the value factor[3]. In this example factor ETFs could be used to ‘plug the gap’ and increase investor exposure to quality and momentum, which has the potential to generate outperformance in the long term and provide exposure to additional sources of return. The MSCI World Momentum Index alone has returned more than 20 per cent in 2024 to date[4], making a momentum strategy an attractive potential diversifier given the relentless rise of the ‘magnificent seven’ (Microsoft, Amazon, Apple, Tesla, Alphabet, Nvidia and Meta) technology stocks.
The cyclical nature of factors means they are also an efficient way to take a view on current market conditions. Traditionally, some investors have used sector exposures to perform tactical tilts in favour of a sector that may perform well during a particular phase in the business cycle – for example, tilting towards utilities or consumer staples in an economic slowdown. Factor ETFs can act as a complement to such strategies, or even an alternative that research tells us may provide better long-term outcomes[5], as investors get exposure to stocks with resilient characteristics across multiple sectors in one trade.
The key differentiator when it comes to factor ETFs, as compared to a traditional active manager that might offer factor strategies, is ease of access. Investors and advisers can mix and match factor strategies to dial in a portfolio for what’s appropriate to client needs, goals and market views, in a simple, liquid and low-cost vehicle.
Given the current volatility of markets, and their susceptibility to short-term ‘shocks’ from macro risks like inflation and geopolitical tensions, we believe having the ability to access selective strategies as an investor, and pivot when circumstances change, is crucial.
Tamara Haban-Beer Stats is a director and ETF specialist at BlackRock.
Disclaimer: opinions are subject to change. They are not a guarantee of future results. This information should not be relied upon as research, investment advice or a recommendation. Diversification and asset allocation may not fully protect you from market risk.
[1] Source: MSCI data as of 31 December 2023. Quality represented by MSCI World ex Australia Sector-Capped Select Index, Value represented by MSCI World ex Australia Enhanced Value Index, Momentum represented by MSCI World ex Australia Momentum Index, broad market index represented by MSCI World ex Australia Index
[2] Source: BlackRock data as at 22 March 2024
[3] Source: BlackRock data as of September 2023
[4] Source: BlackRock Investment Institute, 3 April 2024. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index
[5] Source BlackRock analysis of reward to risk ratio factors vs industries, 1963-2023
