An Exploration of investment style and factor investing.
August 2016
As many readers may know, I spent a significant amount of time in an earlier stage of my career working with major institutional investors to develop, test and implement quantitative investment strategies. During this time I gained tremendous insight into the science of Investment Style and the corresponding notion of Factor Investing. As those insights solidified, they grew into a set of core investment beliefs which guide me today and serve as the basis for our “Active Value” investment approach in the ACE Fund.
To relate the two concepts noted above, if an “investment style” can be described as any consistent and broadly applied method for deciding what securities to buy and sell (eg. value investing), then “factor investing” is simply the implementation of that investment style in a quantitative, systematic or model-driven way. Investment factors such as size, quality, value, beta, liquidity and momentum are well studied and most legendary investors tend to specialize in applying a particular set of factors to their investment activities, in either a systematic or discretionary way.
The Active Value Approach
Our Active Value approach can be summed up as this: We are looking for cheap stocks that are getting better and that possess value unlocking catalysts which will support their continued improvement. The approach involves both a quantitative foundation based on the systematic application of value (cheap assets) and relative strength (getting better) factors, and a qualitative overlay which places high weights on a company’s management skill, operating environment and catalysts (opportunities for growth).
Quantitative Foundation
Cliff Asness is Founder and Chief Investment Officer at AQR Capital Management, an asset manager based in Greenwich, Connecticut. He has produced one of the most comprehensive bodies of academic research on quantitative / factor investing anywhere and was recently named one of the 50 Most-Influential People in Global Finance by Bloomberg. Several of Cliff’s exceptional papers focus on the intersection of value and momentum as factors which present consistently positive return premia across markets and asset classes, while also being negatively correlated to each other. This last point is incredibly important as it means that a strategy which combines these two factors will have higher returns and lower volatility than either factor can produce independently. It has long been known academically that of the primary investment styles, value provides the most consistent returns over time while momentum is the most profitable, albeit with high volatility. As a result, most investors follow some version of value investing or momentum investing, but AQR was the first major research organization to jointly examine these factors at an institutional level. While the application of our investment approach does differ from what is proposed in AQR’s methodology, this work has nonetheless informed our research in a deep and meaningful way and would be a great starting point for any readers looking to gain insight into how we think. For additional insight, I encourage you to see the following:
- “Value and Momentum Everywhere“. Asness, Mokowitz and Pedersen, The Journal of Finance, Vol LXVIII, No 3, June 2013.
- “The Interaction of Value and Momentum Strategies“. Asness, Clifford. The Financial Analysts Journal, March/April 1997.
Qualitative Overlay
Despite possessing many attractive characteristics, we believe that a broad investment program based entirely upon systematic, factor-based investment inputs is sub-optimal for several reasons. First, the universe of investment factors available for study is both finite and known, which leads to many investors using similar models or processes and often results in a “crowdedness” of positioning across certain securities, sectors or asset classes. Crowded trades are prone to quick reversals as investors tend to rush for the exit at the same time. Second, a purely quantitative approach often fails to provide an effective filter against “junk” such as value traps or bad businesses which look good on paper but who end up eventually disappointing the market in a major way and wipe out huge amounts of investor equity. The Canadian capital market is littered with examples of fallen market darlings such as Avigilon, Blackberry, Poseidon Concepts and Autocanada who all ranked very highly in various factor models and as a result were broadly owned as their share prices plummeted.
When considering which qualitative factors can improve on an already strong quantitative foundation, enough weight cannot be given to management quality. Effective management will communicate clearly and openly with investors, have a strong track record of delivering on the business plan and any publicly stated targets or commitments, and take accountability for creating shareholder value. If our qualitative overlay has two main purposes, the first would be to screen out the aforementioned junk and the second would be to identify which companies have the best exposure to visible and material business catalysts. In each case, the character and skill of embedded management have demonstrated exceptional accuracy in helping us distinguish between a good investment and one that just looks that way on paper.
