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.
