Factor Investing Strategies In The Current Market Environment
As recently as mid-February, equity markets were near all-time highs, oil prices were above USD 50 per barrel, volatility was low and credit markets were functioning well. Since then, the global market selloff across all asset classes has been sharp, driven by outlook uncertainty and the search for liquidity. With major indices plunging to new lows amid the news of the effect COVID-19 has had on global economies, investors are looking for ways to isolate risk and capitalize on investment opportunities.
What lies ahead?
While the bad news about COVID-19 is likely to continue over the next couple of weeks as countries brace for a surge in numbers, equity markets could continue to get hit in the near-term before the positive impact of major stimulus packages takes root. Each recent policy decision taken by governments and central banks to support their economies has consequences for assets and securities. “In such tumultuous circumstances it is easy to lose conviction in the fundamental principles of investing, but these will certainly survive this crisis just as they have all previous ones,” says Georg Elsaesser, Senior Portfolio Manager, Invesco Quantitative Strategies. “We need to keep a balanced perspective.”
One of the basic principles of investing is that securities markets are always forward looking. This principle is embodied in the dividend discount model, which is a quantitative method used to predict the price of an asset based on the sum of its future cash flows discounted by an appropriate risk-adjusted rate. While small changes in the expectations of future cash flows or the discount rate can induce the same impact on return, the resulting long-term effects are different. Negative shocks to returns driven by an increase in discount rate tend to be more transitory, whereas negative shocks driven by cash flows could have a longer-term impact on companies. A factor approach can help, whether the crisis gets much worse or ultimately proves less severe than expected.
How to proceed
With global markets in turmoil, factor investing provides a method for investors to screen for opportunities by scanning securities for attributes that seek to increase exposure to factors, or quantifiable characteristics, that the investor believes will deliver the best risk-adjusted returns. Due to the low correlation factors have with each other, diversifying across factors is one way to weather different economic environments, as some factors are less sensitive to economic shocks than others. “For instance, we have found that the equity factors producing the best returns in the equity market downturn have been quality, low volatility and momentum, whereas other factors have exhibited greater sensitivity such as value, size and yield,” comments Elsaesser. A diversified multi-factor portfolio provides an inherent hedge if the crisis were to worsen or the recovery occurs more swiftly.
Impact on local investors
Zainab Kufaishi, Head of Middle East and Africa, Invesco, comments: “Current market prices are reflecting the near-term effects of coronavirus. Whether we have witnessed the bottom of the market is yet unknown. Uncertainty is still high, so volatility is likely to remain high. But to the long-term investor, this effect is one of disruption, not damage. The vast majority of our investors in the Middle East have a long-term horizon with their investments, and should not try to foresee which factor will do well in the short-term. It is important not to forget the basic framework of diversification, discipline and time in factor investing.”
