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Style Premia for a Low Return World

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Style Premia for a Low Return World

Written by: Corey Hoffstein,  Co-founder & CIO, Newfound Research

There is no shortage of diverse opinions on Wall Street: it is, after all, what makes a market function.  Yet more and more asset managers are converging in agreement on one important point: we have entered a period of low expected returns in traditional assets. 

The view arises from two critical data points: higher-than-average valuations in U.S. equities and low nominal yields in core bonds.

For the former, we can look towards the Shiller P/E, which sits just shy of 30.  In the 95th percentile, prior periods where valuations reached this level include right before the Great Depression and the Dot-Com Bubble.

That is not to say that high P/Es necessarily forecast doom and gloom.  Earnings yield (the inverse of P/E), however, is an important input to many expected return models.  Higher P/Es imply lower earnings yields, which imply lower expected returns.

Data Source: Robert Shiller’s data library, as of 4/17.  Calculations by Newfound Research.  Expected equity return is a 50/50 blend of (1) the average of adjusted earnings yield (inverse of Shiller’s CAPE times 1.075) and long-term earnings growth, and (2) the average of long-term earnings growth and current dividend yield.
 

For bonds, the math is a bit simpler: if you hold to maturity, the yield (-to-worst) you buy is the return you get.  Even bond funds do not get much more complicated: for funds that have a fairly stable duration profile, we can invoke the “two times duration minus one” rule.  This rule states that the current yield-to-maturity is the best estimate of annualized return – regardless of whether rates go up or down – over the next “two times duration minus one” years.

For example, we can see in the table below that a broad U.S. Aggregate index has a yield-to-maturity of 2.59% and a duration of 5.7.  This leads us to predict a 2.59% nominal annualized return for this index through 2028 (2017.5 + 5.7 * 2 – 1).

Source: iShares, Calculations by Newfound Research, as of 4/17.
 

With a depressed outlook in both stocks and bonds, traditional diversification may no longer be sufficient.

Enter Style Beta

With low expected returns in traditional beta, it may be prudent to look towards style betas – premia generated from active factor strategies – as a means of both return generation and potential risk mitigation.  Research has identified several strategies that have exhibited significant historical robustness:  

  • Value: Relatively cheap stocks tend to outperform relatively expensive ones.
  • Momentum: Recent outperforming stocks tend to continue to outperform recent underperforming stocks.
  • Defensive: Lower risk stocks tend to outperform higher risk stocks.

With each of these approaches, we find that stocks that rank well tend to outperform stocks that rank poorly.  For example, the highest-ranking value portfolio (i.e. the cheapest stocks) had an annualized return of 13.96% per year, while the lowest-ranking portfolio (i.e. the expensive stocks) had an annualized return of just 8.69%. 

Source: Kenneth French Data Library; AQR.  Calculations by Newfound Research.  “Defensive” factor is captured by AQR’s Quality factor.  Returns calculated over the shared period of 7/1957 through 4/2017. 
 

If we tilt our portfolio away from the low-ranking stocks and towards the high-ranking stocks, we can attempt to capture this performance spread.  This is the fundamental idea behind “smart beta” or “factor” investing.

The potential benefit of introducing style premia goes beyond just return.  When we tilt our portfolio towards high scoring stocks and away from low scoring stocks, we are, in effect, buying an index portfolio and layering on top of it a long/short portfolio (long the high scoring stocks and short the low scoring stocks).  In essence, a factor tilt introduces an entirely new asset to our portfolio. 

Unlike introducing traditional assets, however, we can simply layer this asset on top of existing positions: we don’t need to take capital away from anything else.  Similar to introducing a new traditional asset class, our portfolio can benefit from enhanced diversification introduced by the new exposure.  In fact, in a recent study[if !supportFootnotes][1][endif] we found that even if we believed that active premia offered zero return benefits, we would still allocate for the added diversification.

Embracing Diversification

Due to the differentiated process that each active beta uses, the return streams they generate are not only diversified to traditional betas, but also to each other.  This means that a portfolio can further benefit from a multi-factor tilt, where several active betas are incorporated. 

There are two primary means of achieving a multi-factor tilt: portfolio blend and signal blend.  In the portfolio blend approach, we would combine sleeves representing each active beta.  For example, instead of buying a U.S. equity index ETF, we might buy a different ETF for each of the three factors: value, momentum, and defensive. 

In the signal blend approach, stocks are ranked by their cumulative score across factors.  For example, instead of buying a U.S. equity index ETF, we might buy a single ETF that tilts towards stocks that have strong value, momentum, and defensive characteristics simultaneously.

While there are pros and cons to each approach, a definitive theoretical benefit of the integrated approach is that it creates implicit leverage.  Instead of having to divide our investment into three different approaches, we can use the same dollar to invest in the three approaches simultaneously.    

Conclusion

High equity valuations and low nominal yields have created a world of low expected returns for traditional asset classes.  Style premia – returns generated from active strategies like value, momentum, and defensive – may help investors introduce not only the potential for enhanced return, but added diversification benefits to their portfolios as well.  Even in the case where these active strategies add no return benefit to the portfolio, evidence suggests that the diversification benefit is meaningful enough to warrant their inclusion.  With an integrated multi-factor approach, even just a little exposure has the potential to go a long way.

[1] https://blog.thinknewfound.com/2017/06/factors-financial-planning/
DISCLOSURES
Certain information contained in this presentation constitutes “forward-looking statements,” which can be identified by the use of forward-looking terminology such as “may,” “will,” “should,” “expect,” “anticipate,” “project,” “estimate,” “intend,” “continue,” or “believe,” or the negatives thereof or other variations or comparable terminology. Due to various risks and uncertainties, actual events or results or the actual performance of an investment managed using any of the investment strategies or styles described in this document may differ materially from those reflected in such forward-looking statements. The information in this presentation is made available on an “as is,” without representation or warranty basis.
There can be no assurance that any investment strategy or style will achieve any level of performance, and investment results may vary substantially from year to year or even from month to month. An investor could lose all or substantially all of his or her investment. Both the use of a single adviser and the focus on a single investment strategy could result in the lack of diversification and consequently, higher risk. The information herein is not intended to provide, and should not be relied upon for, accounting, legal or tax advice or investment recommendations. You should consult your investment adviser, tax, legal, accounting or other advisors about the matters discussed herein. These materials represent an assessment of the market environment at specific points in time and are intended neither to be a guarantee of future events nor as a primary basis for investment decisions. Past performance is not indicative of future performance and investments in equity securities do present risk of loss.
Investors should understand that while performance results may show a general rising trend at times, there is no assurance that any such trends will continue. If such trends are broken, then investors may experience real losses. The information included in this presentation reflects the different assumptions, views and analytical methods of Newfound as of the date of this presentation.  This document contains the opinions of the managers and such opinions are subject to change without notice. This document has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. This document does not reflect the actual performance results of any Newfound investment strategy or index.
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