The election of Trump as president of the United States of America has increased uncertainty. After initial doubts regarding his presidency markets quickly rallied as policies were expected to be more business-friendly and supported by expectations of tax cuts. Slowly this buoyant mood is being replaced with lingering doubts. For instance, reports from within the Trump administration raise expectations of trade wars, especially after the Trans-Pacific Partnership has been declared dead. In reality the impact on the trade balance could be offset by the strengthening of the dollar which makes imports more favourable (and exports less favourable). Loosening of the purse strings can boost financial assets while further exacerbating the issues regarding government debt. Clearly, a range of outcomes are possible in the (near) future.
Increased uncertainty is an additional challenge to investors. Investors have a few options to manage this. The first is to estimate the impact of policies on the global economy and financial markets and position the portfolio for the expected outcome. When the realised impact is as expected one will profit. However, it is not possible to forecast the future, so to guard against favourable outcomes we prefer another approach and that is to create a diversified portfolio. Diversification can be achieved by investing in sources of return that are uncorrelated. A portfolio can be constructed that is not exposed to any specific (macroeconomic) event. We believe factor investing offers this.
Let’s first introduce the concept of factor investing. Much academic research has been published in recent decades that show the existence of factors and their attractive and diversifying returns. The existence of factors can be explained by three distinct drivers:
(i) Compensation for risks that other investors want or need to transfer
(ii) Behavioural biases of investors causing assets to be “mispriced”
(iii) Compensation for providing liquidity in case of a supply and demand imbalance
We expect the factors to continue to have positive expected returns going forward as the above-mentioned drivers are not likely to evaporate. Investors always want to be compensated for taking a risk, human be¬haviour generally does not change and investors’ ob¬jectives and restrictions will continue to generate sup¬ply and demand imbalances.
By having a detailed understanding of these fundamental elements that drive returns, one can develop smart investment rules that capture these attractive sources of returns. The drivers behind factors are typically different than those of traditional investments and as such offer diversification. For instance, when behaviour is driving factor returns this is not related to the state of the economy. Therefore, in every stage of the business cycle factor investing can offer returns.
Academia has identified a plethora of factors, many of which are unlikely to generate attractive returns after taking transaction costs into account. To avoid these, a robust investment process needs to be applied that identifies and applies true factors that are supported by a strong economic rationale and can deliver positive expected returns after costs in the long run.
The five factors we use at NN IP are:
Performance tends to persist, hence we go long the winners and short the losers.
Benefits from perceived incorrect valuations, hence we go long undervalued assets and short overvalued assets.
Benefits from the tendency that instruments with higher yields outperform those with lower yields, hence we go long the instruments with a high yield and short those with a low yield.
Markets are subject to predictable and excessive buy¬ing and selling pressures in the short term, hence we go long excessive supply and short excessive demand.
Implied volatilities are generally higher than realised volatilities because implied volatility is a compensation, not an expectation, of volatility. We pay realised volatility and receive implied volatility.
A few possible outcomes are discussed in the introduction but the fund has weathered a clear example of uncertainty: Brexit. A referendum, being a binary outcome, is always surrounded by uncertainty especially given the stakes for this one. As the referendum loomed closer markets expected Great Britain to remain. Of course, eventually voters wanted Britain to exit the European Union which was a surprise and a huge shock to financial markets. A fund such as the NN (L) Multi Asset Factor Opportunities had positive returns in the days before the referendum and after, clearly indicating a portfolio of factors are not (overly) exposed to any single event. Individual factors were affected but the low correlations were apparent (our five factors have long term correlations ranging from 28% to -13%1), for instance the negative impact on Equity Value was more than offset by Equity Momentum. The benefit of applying factors on multiple asset classes was also clear as commodities had virtually no exposure to the Brexit event. Thereby the fund chugged along steadily by being exposed to return sources driven by the three distinct – and different – drivers of returns.
The future might be surrounded by a great deal of uncertainty but this can be navigated by building robust investment portfolios. Factors are uniquely suitable to add to portfolios due to their attractive positive expected returns and their low correlations, not just with each other but also with traditional investments. Therefore adding factor investing across asset classes to portfolios improves robustness to better weather the uncertainty.
Stan Verhoeven is lead portfolio manager of the NN (L) Multi Asset Factor Opportunities fund