Factors Are Making a Comeback

06 September 2022

5 min read

Inigo Fraser Jenkins| Co-Head—Institutional Solutions

Alla Harmsworth| Co-Head—Institutional Solutions; Head—Alphalytics

At the most basic level, portfolios consist of combinations of return streams, whether those streams come from asset classes, an individual physical asset or a factor strategy. We’ve made the case for several years that factors should be an important part of asset allocation and, with some limits, interchangeable with asset classes.

The strategic case for factors is distinct from the question of whether investors can effectively time them; instead, the strategic case holds that factors may help from both a return perspective and as a source of diversification. Even if investors agreed with that case in principle, factors’ performance woes over the past few years have been enough to make many investors hesitant.

Fortunes Have Improved for Factors Recently

We never bought into the notion that factors had been “arbitraged out” by an inflow of capital, but they can be less effective for long periods. That slump ended over the past year, as factors’ effectiveness has rebounded (Display). The changing fortune of the value factor is part of that upturn, but momentum and quality factors have also delivered positive returns since mid-2021 in the US.

Aggregate Factor Risk-Adjusted Returns by Region

Based on Five-Year Trailing Annualized Return/Risk

Five-year annualized return/risk of factors in various regions of the world

Historical analysis and current estimates do not guarantee future results.
Chart shows the five-year annualized return/risk ratios averaged for seven factors—price to book, dividend yield, return on equity, long-term growth, price momentum, small-cap and free-cash-flow yield—in each region. Baskets are rebalanced quarterly, and we use total long-short USD returns.
December 31, 1994, through May 31, 2022
Source: FactSet, Institutional Brokers' Estimate System and AB

Why should investors believe that factors can remain effective? The recent performance turn will likely convince more investors that subpar factor performance in recent years was cyclical, not structural. That would break the narrative that factors somehow don’t matter or are inappropriate as explicit building blocks in asset allocation decisions.

Value and the Link with Inflation

There’s a specific case to be made for the value factor, too. Over the past century (Display), there’s been a link between value’s effectiveness and inflation. When inflation has been elevated, value has tended to fare better; it’s been less effective in lower-inflation environments. This relationship implies that at least some of value’s underperformance in the decade preceding the past 12 months stemmed from actual inflation persistently undershooting expectations.

The Efficacy of Value Is Linked to Inflation

The relationship between US CPI and value annualized returns since 1936

Historical analysis and current estimates do not guarantee future results.
January 1, 1936, through March 31, 2022
Source: Kenneth R. French Data Library, Thomson Reuters Datastream and AB

Of course, inflation is clearly not the only factor that determines value’s effectiveness, and we see two structural headwinds remaining. For one thing, technological innovation has destroyed the protective “moats” around some industries, so an industry that’s very cheap by historical standards may actually be at the losing end of a profound change in traditional competitive dynamics—not just out of favor cyclically.

Also, over the past decade, the primary focus of corporate investment has shifted from tangible to intangible assets. Different accounting treatments raise important questions about the best way to measure value. Because these forces are present, investors shouldn’t expect traditional value definitions to necessarily perform in line with their longer history.

In previous research, we’ve also distinguished between the stocks in a value trade: those that perform well as a direct function of inflation versus those that shine as a result of the indirect mechanism of the typical central bank inflation response—banks, in particular. At the moment, both parts of the value trade can do well; over longer strategic horizons, we’re less sure about the second group.

Low Volatility and More: It’s Not Just About Value

Value isn’t the only factor that has promise; low volatility also stands out to us. This factor tends to suffer when inflation expectations rise quickly, which happened last year. However, in the main episodes since the 1970s, when inflation expectations peaked and then subsided or stayed within a range, low volatility’s risk-adjusted performance has fared well versus both equities and 60/40 strategies. Moreover, we note that low volatility only tends to materially underperform in periods with the strongest market returns, and we expect market returns to be subpar.

Another factor that we see standing out from a strategic perspective is quality—higher-quality stocks have tended to deliver attractive risk-adjusted returns over longer horizons. Finally, there’s momentum. In a sense, it’s hard to have a fundamental strategic view on momentum given its chameleon-like changing composition. But having said that, we believe that it has a role in a broader allocation. This is especially the case when price trends can become established and entrenched, as has been the case in some inflationary periods. So, in our view, momentum has a role to play in inflation protection.

The strategic case for factors isn’t just about their ability to plug the “return gap” between the performance investors need and the returns that are available. We think factors also have a role to play in portfolio risk control. We’ve shown that they have a long history of providing more consistent diversification than asset classes, with the average pairwise correlation of factors more stable than that of asset classes. We understand that some investors may remain skeptical about factors, but we feel that they have a strategic role to play—and a multi-purpose one at that.

The views expressed herein do not constitute research, investment advice or trade recommendations, and do not necessarily represent the views of all AB portfolio-management teams and are subject to change over time.

About the Authors

Inigo Fraser Jenkins

Inigo Fraser Jenkins is Co-Head of Institutional Solutions at AB. He was previously head of Global Quantitative Strategy at Bernstein Research. Prior to joining Bernstein in 2015, Fraser Jenkins headed Nomura's Global Quantitative Strategy and European Equity Strategy teams after holding the position of European quantitative strategist at Lehman Brothers. He began his career at the Bank of England. Fraser Jenkins holds a BSc in physics from Imperial College London, an MSc in history and philosophy of science from the London School of Economics and Political Science, and an MSc in finance from Imperial College London. Location: London

Alla Harmsworth

Alla Harmsworth is Co-Head of Institutional Solutions and Head of Alphalytics at AB. She was previously head of European Quantitative Strategy at Bernstein Research. Prior to joining Bernstein in 2015, Harmsworth worked for two years on Nomura's Institutional Investor-ranked European Equity Strategy and Quantitative Strategy team. Her previous experience includes seven years at Fidelity as a quantitative analyst and portfolio manager, along with stints at Nikko Asset Management and ABN AMRO. Harmsworth holds a BA (Hons) and an MA in philosophy, politics and economics from University College Oxford and an MSc in economics from the London School of Economics and Political Science. Location: London