Lazard Equity Advantage Team Letter from the Manager DEC A Better Kind of Beta. The Style Factors. What are the style factors?

Transcription

1 Lazard Equity Advantage Team Letter from the Manager DEC 2015 A Better Kind of Beta An astute investor might already have concluded that smart beta is nothing new. And they would be right; the team at Lazard has offered multi-factor smart beta investing for two decades, but under a different label; quantitative, or systematic, investing. Although smart beta has recently garnered a lot of press attention, investors are often still confused as to what exactly it is. Broadly, smart beta can be viewed as a half-way house between passive investing, which tracks market capitalisation indexes to capture beta, i.e., market exposure, and active investing, which aims to capture alpha i.e., the excess returns of a fund relative to the return of the benchmark. In other words, any returns due to the fund manager s investment aptitude. Smart beta strategies attempt to deliver a better risk/return trade-off than conventional market cap weighted indices by using alternative weighting, based on factors such as low volatility, value or momentum. The smart is provided by the fact that, historically, these indexes have earned excess returns over market capitalisation weighted indexes and experienced higher Sharpe Ratios. 1 Smart beta funds come in two broad flavours, single-factor and multi-factor. By factor, we simply mean any consistent characteristic that is important in explaining the risk or returns of a group of stocks that make them more likely to beat the market (we consider the major factors below). As the name suggests, single-factor funds focus on a single, easily measurable investment factor, while multi-factor funds incorporate a variety of investment factors when creating a portfolio/index. Although as the industry expands, product profiles are becoming more complex, plain vanilla single-factor funds still dominate; products with exposure to more straightforward strategies account for some 70% of total smart beta exchange traded product assets. 2 The Style Factors What are the style factors? Academic research has uncovered a multitude of factors that claim to offer returns in excess of the market cap weighted benchmark, but most of these prove unstable, illiquid, or difficult to replicate in live portfolios. Nonetheless, a number of factors can be identified that deliver excess returns over the medium- to long-term, and they can broadly be classified into the following style groups: Value Market sentiment (momentum) Low volatility Quality Growth The choice of how to measure each attribute can vary significantly among managers and the pattern and magnitude of returns will be dependent on the choice of criteria. Next we examine the various factors that go into creating our multi-factor funds in more depth and look at how our proprietary interpretation and blend of each factor is chosen to produce maximum returns and minimum volatility for investors. Value Value investing is one of the best known investment styles in stock investing; it is also the investment style of one of the most celebrated modern day investors, Warren Buffett. Therefore, it is no coincidence that the most successful single-factor smart beta strategy in terms of asset gathering has been fundamental indexing, which aims to capture the value risk premium. However, value can be defined in a multitude of ways and the payoff from investing in high dividend yield differs to investing in low price-to-book companies. To provide more consistent exposure to the returns from value investing we believe it is important to incorporate not only cyclical value metrics like price-to-book, which will perform extremely well in a market recovery period, but also more defensive value measures such as cash flow. We also incorporate value relative to return-on-equity, to filter out companies that are cheap for a particular reason, versus those that are just temporarily unloved. LR25885

2 2 Positive value investment (i.e., buying value stocks or long only value investments) requires a contrarian approach, effectively providing liquidity to investors who cannot cope with the drawdowns and troughs of value investing. Lazard s strategies are better suited to manage drawdown risks as we are well diversified and relatively neutral with regards to industry positioning, thereby managing through periods where particular sectors remain out of favour and undervalued for prolonged periods of time. There is also a value premium related to slow information absorption into small/mid-caps, which our process can extract. Negative value investment (i.e., underweighting expensive stocks) usually involves taking advantage of over-optimism as a behavioural bias. In practice, we consider that difficulties in shorting a large number of stocks, either because of liquidity or financing constraints, leads to information inefficiency in many expensive stocks. Systematically underweighting these stocks leads to a volatile return premium that we are able to capture through a risk-controlled process. Market Sentiment Market sentiment (or momentum) is the phenomenon by which securities that have performed well relative to peers in the recent past continue, on average, to outperform, while securities that have performed poorly continue to underperform. Our research has shown that the main driver of price momentum is the gradual impact of macro data on groups of stocks. During the 1990s, these groups were mostly defined by sectors, such as technology, media and telecoms, while in the last 10 years these groups have become more diverse and have included exposures to geographic revenue (e.g., emerging markets), commodity price sensitivities (e.g., oil price) and credit (e.g., financial crisis). In other words, market sentiment arises from macroeconomic data releases in the same direction, and the gradual reflection of these trends in the price of groups of stocks. Similar to value investing, market sentiment investing does not have to be confined to a single measure, such as price momentum. Through research we have found that we can significantly improve upon the return and risk characteristics of a simple price momentum strategy by incorporating other dimensions of market sentiment. Exhibit 1 demonstrates the significant improvements that can be achieved in terms of returns from exposure to a varied source of information signaling momentum in an underlying stock, not just a simple measure of how well the stock has done over the last year as measured by 12-month price momentum. Exhibit 1 The Returns Available to Market Sentiment Investors Vary Significantly Depending on Criteria Used Cumulative Quintile Spreads (%) Lazard Equity Advantage Global Momentum Month Price Momentum As of 30 June 2015 The return in the charts represents the cumulative returns from portfolios constructed using equal weights of the top 20% minus the bottom 20% of securities in the Lazard Global stock universe (of approximately 5000 companies). The top and bottom 20% stocks are selected using the proprietary Lazard Global Momentum model and 12 month price momentum. 12 month price momentum is calculated by ranking stocks based on the previous 12 months total returns from highest to lowest. Factor returns shown in USD, gross of management fees. It does not represent any actual portfolio managed by Lazard. Past performance is not a reliable indicator of future results. The value of investments can fall as well as rise. Investors capital may be at risk. Source: Lazard/Factset

3 3 In our portfolio construction process we use a diverse set of factors to capture sentiment incorporating news flow, volume traded, analyst data and prices. Equally important is the fact that while sentiment investing is rewarding over the long term, in the short term sentiment strategies are subject to reversals in performance typically coinciding with a turn in the overall direction of the equity market and the underlying global economy. Exposure to naive momentum, such as merely buying companies that have performed the best over the last 12 months, can exhibit significant drawdowns during such turning points in the cycle as illustrated in exhibit 2. A more diversified and risk adjusted measure of performance can significantly reduce the drawdowns associated with trend following momentum strategies around market turning points. Exhibit 2 Market Sentiment Investing Suffers from Drawdowns that are made Significantly Worse if Risk is not Removed from Simple Momentum Measures Maximum Drawdown (%) 0 Lazard Equity Advantage Global Momentum -25 Risk adjustments limits drawdown 12 Month Price Momentum -50 Momentum drawdowns can be severe As of 30 June 2015 Max drawdown is an indicator of the risk of a portfolio chosen based on the Lazard Global Advantage Momentum model and 12 month price momentum respectively. It measures the largest single drop from peak to bottom in the value of the two portfolios before a new peak is achieved. Factor returns shown in USD, gross of management fees. It does not represent any actual portfolio managed by Lazard. Past performance is not a reliable indicator of future results. The value of investments can fall as well as rise. Investors capital may be at risk. Source: Lazard/Factset Low Volatility Low volatility, a strategy with a long pedigree, has seen interest resurface in the wake of the financial crisis. We believe exposure to the low volatility factor is more efficiently achieved through portfolio construction, rather than targeting a direct exposure to low volatility stocks or limiting the universe to low volatility equities. By targeting lower risk we move the portfolio away from countries, sectors and stocks that tend to exhibit a higher degree of unrewarded risk. We identify these by using two customised risk models, capturing both longer-term and shorter-term risk factors, and then employing significant diversification to ensure that the portfolios are not overly exposed to any one low risk sector or market segment. In targeting a lower risk portfolio as part of the portfolio construction process, rather than as a stock selection criterion, we are able to benefit from significant efficiencies. Through our process, we can identify not only companies that are low risk but also those that are attractive on our fundamental criteria. Quality To assess the quality of a company, we study companies reported earnings vis a-vis cash flow. Accounting rules and the market s short-term focus have resulted in immense pressure on companies to focus on meeting short-term earning expectations. However, analysis of cash flow statements allows for a better insight into the quality of a company s earnings. Those that meet short-term earnings announcements through accounting adjustments and financial engineering tend, on average, to underperform in the medium-term. On the other hand, high quality stocks have stable returns and low earnings volatility and, in conjunction with value, this helps us identify stocks that migrate from value to growth. Underweighting low quality stocks also reduces the portfolio drawdowns in volatile environments, albeit not relative drawdowns during junk rallies that tend to be driven by low quality companies.

4 4 Growth Financial statements provide information that, while not that useful in isolation, can, when grouped together, help identify stocks that (1) have growth opportunities and are generating financial returns to exploit these, and (2) are more likely to grow organically. Our process aims to identify companies that are well positioned to experience above average growth in the future. Albeit not one of the broad style groups of factor investing outlined above, we incorporate growth into our factor portfolios, not necessarily because the premium to this factor is large over time, but because it acts as a diversifier when some of the other factors are struggling. Given its low turnover nature one could view this as a form of insurance that provides the consistency of returns that our multi-factor portfolios target. The returns attributable to this factor are more modest and can be well below the radar of most active investors, but our experience shows that including growth provides a significant diversification benefit due to its negative correlation with other factors, particularly value and sentiment. The Advantages of Multi-Factor Investing Performance and diversification Although factor indexes have outperformed their market cap weighted counterparts since and each factor is expected to provide positive excess returns over time, returns are cyclical and some factors have experienced periods of prolonged underperformance e.g., value during the financial crisis or market sentiment in the early part of the recovery, post-crisis. Therefore, by simply combining single-factor smart beta strategies, investors could potentially end up with significant stock-specific risk. It makes sense that diversifying among a number of factors can carry significant advantages in terms of reducing the volatility of the strategy s returns. Ultimately, when combining factors in a multi-factor portfolio investors needs to take into account a variety of variables. The expected return is only one of these, and it does not necessarily follow that investors should target higher exposure to factors that are expected to produce larger returns. As previously noted, while on an absolute basis multi-factor mandates are expected to do better than the market over time, individually factor s can go through long periods of underperformance on a risk-adjusted basis. As such, depending on the investor s risk appetite and liquidity requirements, the volatility, drawdowns and turnover necessary to maintain a factor exposure are equally important. As an example, let s consider two factors. Market sentiment has, potentially, a very high payoff, but the turnover required to benefit from the factor is also high. Furthermore, a larger allocation to the factor is necessary in order to reap returns. The reverse is true with quality, which is a relatively low turnover factor with low volatility of returns. Additionally, in order to gain exposure to quality, a large allocation to this factor is not necessary. Therefore, it is essential to consider these issues when allocating factor weights, but it is also important to monitor the pattern of factor returns and their correlation e.g., an increase in market sentiment exposure is often followed by a period in which market sentiment is correlated with high risk stocks. To guard against undue concentration in a multi-factor portfolio it is essential to be aware of these risk factors. Flexibility Unlike with a passive index fund, or a single-factor smart beta fund, within an actively managed smart beta fund institutions have full control over the selection and weights of individual factor indexes within a multi-factor index and can adjust the strategic factor allocation to account for specific constraints, such as environmental and social governance policies etc. Multi-Factor with Pedigree Our multi-factor portfolios employ a set of balanced style criteria that have been researched and refined over 20 years. They also have the added benefit of having been implemented in live portfolios for our clients over this period, in a variety of global-, regional- and country-specific mandates. While we are willing to tailor our strategies to accommodate a client s risk appetite, the genesis of our approach is firmly based in the team s investment philosophy that has served to successfully provide our clients with consistent factor returns long before the advent of the smart beta/multi-factor terminology. Exhibit 3 below illustrates the differences in the potential payoff available to investors from a simple smart beta value factor versus our proprietary value factor. While investors are rewarded by having exposure (beta) to simple valuation criteria (in this case price/book, price/ earnings, price to sales and dividend yield equally weighted), more comprehensive value metrics can significantly improve the outcome for investors.

5 5 Exhibit 3 Comprehensive Valuation Criteria Offers Significant Upside to Simple Value Factors Cumulative Quintile Spreads (%) Lazard Equity Advantage Global Value ALPHA Value Combo (P/B, P/E, P/S, D/Y) BETA As of 30 June 2015 The return in the charts represents the cumulative returns from portfolios constructed using equal weights of the top 20% minus the bottom 20% of securities in the Lazard Global stock universe (of approximately 5000 companies). The top and bottom 20% stocks are selected using the proprietary Lazard Global Value model and the Value Combo model. The Value Combo model is calculated combing equally four valuation ratios (price/book,, price/earnings, price/sales and dividend yield). Factor returns shown in USD, gross of management fees. It does not represent any actual portfolio managed by Lazard. Past performance is not a reliable indicator of future results. The value of investments can fall as well as rise. Investors capital may be at risk. Source: Lazard/Factset Concluding Remarks Not all smart beta strategies are created equal the specific combination of factors and timing will all determine the investment outcome but, in particular, the decision of whether to use single or multi-factor. Honed over twenty years, Lazard s actively managed multi-factor products are built to provide the benefits of a multi-factor strategy, while minimising the risks. When choosing a Lazard multi-factor strategy, investors benefit from the skill and long-standing experience of the team in multi-factor selection, combination and diversification, as well as ongoing research and risk monitoring. Our strategies are not only built on the premise that investors are rewarded by exposing their portfolios to single factors over time, but also the realisation that styles fall in and out of favour, so investors need to diversify their exposure to a number of investment factors in order to fulfil their investment objectives. We have found this exposure to several factors provides for far greater consistency of performance both over the long- and short-term.

6 6 Notes 1 Foundations of Factor Investing, p.19, MSCI Research Insight, December A Global Guide to Strategic-Beta Exchange-Traded Products, p.10, Morningstar, June Based on MSCI s individual factor indexes versus their market capitalisation-weighted counterparts since 1988, (Introducing MSCI IndexMetrics, MSCI Research Insight p. 7 December 2013). Important Information Published on 11 December Certain information included herein is derived by Lazard in part from an MSCI index or indices (the Index Data ). However, MSCI has not reviewed this product or report, and does not endorse or express any opinion regarding this product or report or any analysis or other information contained herein or the author or source of any such information or analysis. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any Index Data or data derived therefrom. The MSCI Index Data may not be further redistributed or used as a basis for other indices or any securities or financial products. This is a financial promotion and is not intended to be investment advice. In the UK this document, which is supplied for information only, is for distribution only to professional investors and advisers authorised to carry out business under the Financial Services and Markets Act This document reflects the views of Lazard Asset Management LLC or its affiliates ( Lazard ) and sources believed to be reliable as of the publication date. There is no guarantee that any projection, forecast, or opinion in this material will be realized. Past performance does not guarantee future results. This document is for informational purposes only and does not constitute an investment agreement or investment advice. References to specific strategies or securities are provided solely in the context of this document and are not to be considered recommendations by Lazard. Investments in securities and derivatives involve risk, will fluctuate in price, and may result in losses. Certain securities and derivatives in Lazard s investment strategies, and alternative strategies in particular, can include high degrees of risk and volatility, when compared to other securities or strategies. Similarly, certain securities in Lazard s investment portfolios may trade in less liquid or efficient markets, which can affect investment performance. Australia: FOR WHOLESALE INVESTORS ONLY. Issued by Lazard Asset Management Pacific Co., ABN , AFS License , Level 39 Gateway, 1 Macquarie Place, Sydney NSW Dubai: Issued and approved by Lazard Gulf Limited, Gate Village 1, Level 2, Dubai International Financial Centre, PO Box , Dubai, United Arab Emirates. Registered in Dubai International Financial Centre Authorised and regulated by the Dubai Financial Services Authority to deal with Professional Clients only. Germany: Issued by Lazard Asset Management (Deutschland) GmbH, Neue Mainzer Strasse 75, D Frankfurt am Main. Hong Kong: Issued by Lazard Asset Management (Hong Kong) Limited (AQZ743), Unit 29, Level 8, Two Exchange Square, 8 Connaught Place, Central, Hong Kong. Lazard Asset Management (Hong Kong) Limited is a corporation licensed by the Hong Kong Securities and Futures Commission to conduct Type 1 (dealing in securities) and Type 4 (advising on securities) regulated activities. This document is only for professional investors as defined under the Hong Kong Securities and Futures Ordinance (Cap. 571 of the Laws of Hong Kong) and its subsidiary legislation and may not be distributed or otherwise made available to any other person. Japan: Issued by Lazard Japan Asset Management K.K., ATT Annex 7th Floor, Akasaka, Minato-ku, Tokyo People s Republic of China: Issued by Lazard Asset Management. Lazard Asset Management does not carry out business in the P.R.C. and is not a licensed investment adviser with the China Securities Regulatory Commission or the China Banking Regulatory Commission. This document is for reference only and for intended recipients only. The information in this document does not constitute any specific investment advice on China capital markets or an offer of securities or investment, tax, legal, or other advice or recommendation or, an offer to sell or an invitation to apply for any product or service of Lazard Asset Management. Singapore: Issued by Lazard Asset Management (Singapore) Pte. Ltd., 1 Raffles Place, #15-02 One Raffles Place Tower 1, Singapore Company Registration Number W. This document is for institutional investors or accredited investors as defined under the Securities and Futures Act, Chapter 289 of Singapore and may not be distributed to any other person. South Korea: Issued by Lazard Korea Asset Management Co. Ltd., 10F Seoul Finance Center, 136 Sejong-daero, Jung-gu, Seoul, United Kingdom: FOR PROFESSIONAL INVESTORS ONLY. Issued by Lazard Asset Management Ltd., 50 Stratton Street, London W1J 8LL. Registered in England Number Authorised and regulated by the Financial Conduct Authority (FCA). United States: Issued by Lazard Asset Management LLC, 30 Rockefeller Plaza, New York, NY