The three environments
In this article we will be looking at investment in three different spheres. We will be looking at how these spheres interact together to generate investment returns.1. The Economy2. Different Industries in the Economy3. The MarketThe ‘economy’ is the state of a nation or the globe economically. The economy is made up of different industry sectors: technology, industrial, finance, healthcare, energy, cyclical goods etc. The whole industry is made up of all the companies in that sector / industry. For example, in the Industrial and Mining sector you have a company Anglo American and their competitors. These companies perform differently throughout different stages of the economic cycle. The ‘market’ is the way that people view the value of those companies. People see value differently and that is why the stock price of companies in the market fluctuate so much. Market value can be calculated using hard fact and it can be largely based on human bias and perception of value.
What is factor investing?
These three environments work together and investors try to understand their relationship, so that they can invest accordingly and generate return on investment. There are many investment views and economic drivers of return. These views track different ways that return can be generated at different times in the economy. When the economy is in different stages, investment views and macro-economic variables show that certain investments should outperform others. Below is a graph representing what sectors / industries perform well during different economic cycles:
When people speak about trying to ‘time-the-market’, an example of this is illustrated in the graph above. Investors will try to predict the overall economic condition (expansion, peak, trough, recovery) and market condition (bull, bottom, bear, top). From there, they try to invest in the specific companies inside the respective performing industries.Another example of ‘timing-the-market’ is done through Investment Styles (Value/Growth, Momentum, Quality, Volatility, Investment):
Value/Growth, Momentum, Quality, Volatility and Investment, these are all different Investment Styles. There are different investment levers one can pull in order to generate returns throughout market and economic cycle changes. This targets specific drivers and tries to bring about alpha generation. Alpha generation simply means the return an investment generates above the market returns while investors trade actively. When we blend the combination of these strategies (Value/Growth, Momentum, Quality, Volatility and Investment) together, it is referred to as Multi-Factor investing.
Why is multi-factor investing so valuable?
As we target specific drivers of return across economic cycles, there are different return generation levers that we can pull as the economy changes. We are going to use an example. Look at the ‘Investment Style’ graph to follow this example.If you are an investor and you are holding large exposure to Value stocks in your portfolio, the market is in a Bull Market and the economy is in a Recession to Early Recovery stage. Within a few months, the market turns into a ‘Market Peak’ where Momentum stocks start to outperform. As an investor, by the time you try to adjust to hold less Value stocks and more Momentum stocks, you could have already missed the opportunity to generate large alpha.By holding a portfolio with multiple-firing-factors to generate return, you reduce risk/volatility, enhance diversification and have greater ability to generate excess returns on your portfolio by taking on little-to-no extra risk. Many believe, higher risk will always bring higher return. This is not the case, some risk can be purely downside risk. This is measured by something asset managers call the ‘Sortino Ratio’. By holding multiple investment strategies according to factor-modelling, generating higher returns at lower cost is made possible.At Fairtree Invest, our solutions are designed with an element of multi-factor investing.Our unit trusts combine systematic quantitative factor-based investing with fundamental active management overlays. We also blend tactical tilting and strategic asset allocation methods to the diversified blend of worldwide asset class exposures. Namely global property, local property, corporate credit, offshore and local equity, high concentration equity and quantitative factor-based-equity modelling. We also have our personalised stock portfolio and bespoke offerings which brings exposure to the world of hedge funds and all their additional investment levers.
Read more on Factor Investing, Tactical tilting and Strategic Asset Allocation in an interview with Wessel Grobler.
– Kheara Kroggel
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Article Credits: https://www.blackrock.com/us/individual/investment-ideas/what-is-factor-investing, https://www.blackrock.com/us/individual/investment-ideas/what-is-factor-investing/factor-commentary/andrews-angle/fending-off-factor-investing-fallacies, https://www.economist.com/finance-and-economics/2019/07/18/lots-of-investors-bet-on-factors-such-as-size-value-and-momentum?frsc=dg%7Ce, https://seekingalpha.com/article/4270469-bear-markets-understand-fear