LEADERSHIP SERIES Translating Factors to International Markets Strategies that combine the potential diversification benefits of international exposure with the portfolio-enhancing benefits of factors may be compelling options for investors. Darby Nielson l Managing Director of Research, Equity and High Income Bobby Barnes l Quantitative Analyst, Equity and High Income Paul Baiocchi l Vice President, Sector and ETF Investment Strategy Key Takeaways Factors can be effective portfolio building blocks because they drive the risk and return of stocks and have been proven to enhance portfolios over time. Although factor investing has largely been U.S.-focused up to this point, the excess returns of many factors have been just as compelling in international markets. Further, exposure to international stocks may help to reduce risk, through greater diversification and lower correlations among investments. By offering the potential benefits of exposure to both international stocks and to factors, international factor strategies may serve as effective complements to existing portfolios. Investors pursuing higher returns, reduced risk, or specific investment outcomes are increasingly turning to factors as portfolio building blocks. Up to this point, factor investing has largely been focused on U.S. markets. But many factors have had similar or even more compelling results in international markets (Exhibit 1, page 2). And many of the market dynamics and investor behaviors that help explain why factors have enhanced portfolios over time hold true both for U.S. and international markets. For example, value has outperformed because inexpensive stocks that beat earnings expectations may have greater upside potential than their more expensive peers. The rationale behind momentum investing is largely behavioral: in general, it s not until after a stock is outperforming that investors take notice and look to buy, which allows winners to keep winning. And quality has tended to beat the market because companies with superior profits, strong balance sheets, and stable cash flows often boast a competitive advantage, which tends to lead to consistent outperformance over time. (See our earlier Leadership Series article, An Overview of Factor Investing, for more detail on the benefits of factors.)
Factor-based strategies give investors the opportunity to gain more targeted exposure to desired factors in their portfolios and fine-tune them over time. Take value, for example. Many passive investors use traditional capweighted value style indexes to gain exposure to value stocks. Style indexes generally account for an entire universe of stocks across the value/growth spectrum, and identify them as one or the other or in some cases, both often using a simple combination of value and growth metrics. If growth metrics are included in the selection criteria for value stocks, lackluster earnings growth could cause a stock to fall within the value side of the style index, even though the stock may not be truly inexpensive. As a result, style indexes may not necessarily provide high-conviction value exposure. Exhibit 2 illustrates that, on average, the stocks within an international value factor strategy were cheaper than an international value style index based on four different measures. This is largely because factor strategies do not need to account for an entire stock universe, and can therefore use a targeted definition of value to capture truly inexpensive stocks. As a result, the value factor strategy has outperformed both the broader international index and the value style index over time, and has had stronger risk-adjusted returns (Exhibit 2). International factor strategies as complements to existing portfolios Exposure to international stocks may help reduce risk in a portfolio, through greater diversification and lower EXHIBIT 1: Factors have performed similarly in the U.S. and in international developed markets. International and U.S. Factor Excess Returns EXHIBIT 2: A value factor strategy can screen for inexpensive stocks based on multiple metrics to gain greater exposure to value. Average Valuation Based on Four Key Metrics, 1986 to 2016 International Developed Markets United States Valuation Multiple 29.6 28.4 3.4% 3.4% 3.1% 3.4% 21.1 18.9 20.7 0.3% 0.7% 2.1% 1.7% 1.5% 1.4% 0.8% 2.2% 1.4 1.4 1.8 13.3 7.4 8.4 9.1 Size Value Momentum Quality Low Volatility* Dividend Yield P/B P/E EV/EBITDA P/FCF Annualized Return Information Ratio International Value Factor 9.13% 0.54 International Value Style Index 8.84% 0.28 International Index 7.33% N/A Past performance is no guarantee of future results. Developed-market international (referred to in this article simply as international ) factor portfolios are based on the MSCI World ex. U.S. Index. U.S. factor portfolios are based on the Russell 1000 Index. *The primary objective of low-volatility investing is to reduce risk. However, academic research and historical performance have shown that low-volatility portfolios may also outperform the market over time. Data from Jan. 1986 through May 2017. See Appendix for methodology details. Source: FactSet, as of May 31, 2017. Past performance is no guarantee of future results. International value factor strategy: combined average of stocks in the top quintile by book/price ratio and by earnings yield of the equal-weighted MSCI World ex. U.S. Index; International value style index: MSCI World ex. U.S. Value Index; International index: MSCI World ex. U.S. Index. P/B: Price-to-book ratio; P/E: price-to-earnings ratio; EV/ EBITDA: enterprise value-to-earnings before interest, taxes, depreciation, and amortization ratio; P/FCF: price-to-free-cash-flow ratio. Information ratio: a measure of risk-adjusted return. Source: FactSet, as of May 31, 2017. 2
TRANSLATING FACTORS IN INTERNATIONAL MARKETS correlations among investments. A comparison of the first two columns of Exhibit 3 illustrates that adding international exposure to a U.S. stock portfolio led to lower volatility. International markets also offer a broad opportunity set for investors approximately 75% of the world s companies are headquartered outside the U.S. However, U.S. investors tend to have a large home-country bias, and are generally under-allocated to international stocks. Exhibit 4 shows that although approximately 43% of the total stock market capitalization is located outside the U.S., mutual fund investors in the U.S. hold only approximately 24% of their portfolios in international funds. (For more details on the benefits of international investing, please see our Leadership Series article, Dispelling the Myths of International Investing. ) In contrast to broad international indexes, factorbased international strategies combine the potential diversification benefits of international exposure with the portfolio-enhancing characteristics of targeted factor exposure. Below, we explore how two well-recognized factors may complement existing portfolios. Value Exhibit 3 illustrates that adding an international value factor strategy to a U.S. stock portfolio resulted in higher returns with moderately lower volatility than the U.S.-only portfolio due largely to the enhanced diversification achieved by the international exposure and the higher returns of the value factor. Further, the combination provided even better risk-adjusted returns than the portfolio that combined U.S. stocks with a broader EXHIBIT 3: Adding an international value factor strategy to a U.S.-focused portfolio has enhanced the overall portfolio s risk-and-return characteristics. Measures of Return and Risk U.S. Large Cap U.S. Large Cap + International U.S. Large Cap + International Value Factor Ann. Return 11.51% 10.81% 12.53% Volatility 17.58% 16.20% 17.35% Sharpe Ratio 0.65 0.67 0.72 EXHIBIT 4: U.S. investors are largely under allocated to international stocks. Investor Allocation vs. Stock Market Composition International United States 76% 43% 57% 24% Mutual Fund Allocation Actual Stock Market Capitalization Past performance is no guarantee of future results. Ann.: annualized. U.S. large cap: Russell 1000 Index; International: MSCI World ex. U.S. Index. Sharpe ratio: a measure of risk-adjusted returns. Source: FactSet, as of May 31, 2017. Investor allocation in International and U.S. mutual funds. Source: Morningstar, as of Dec. 8, 2017. 3
international stock index. Note that in the U.S. stock market, investors have embraced style investing, and hold approximately 21% in value style funds (Exhibit 5). In international markets, however, a style approach to investing is behind in its adoption, with only 9% of international assets in value style funds. As shown in Exhibit 2 and in our Leadership Series article Incorporating Factor Strategies into a Style- Investing Framework, a passive style approach to value investing may not necessarily provide high-conviction value exposure. Nevertheless, investors may want to consider increasing their exposure to international value stocks, and a factor-based approach may be a compelling way to do so. Dividend Yield Many investors seeking to earn income from their portfolios opt for U.S. equity-income strategies. However, across multiple sectors, dividend yields from international stocks have exceeded yields from their U.S.-based peers. Therefore, exposure to international dividend-paying stocks may serve to complement a U.S. equity-income approach. Exhibit 6 shows how the addition of an international dividend factor strategy to a U.S.-focused equity income portfolio significantly increased the overall dividend yield. Many U.S. equity income strategies have a dual mandate of seeking capital appreciation and dividend yield. An international dividend factor strategy may complement such an approach, by providing targeted exposure to high-dividend-paying stocks. Thoughtful portfolio construction and controlling for unintended risks When evaluating factor strategies, it s important to understand their underlying methodologies and how EXHIBIT 5: International investors may be underexposed to value stocks, and may want to consider a factor-based approach for high-conviction international value exposure. Investor Allocation in the U.S. vs International EXHIBIT 6: Complementing a U.S. equity-income portfolio with an international dividend factor strategy has provided a higher dividend yield. Dividend Yield U.S. Fund Allocation 64% International Fund Allocation 3.8% 50% 2.5% 21% 29% 27% 9% Core Value Growth Investor allocation in U.S. vs. international mutual funds. Source: Morningstar, as of Dec. 8, 2017. U.S. Equity Income U.S. Equity Income + International Dividend Factor Past performance is no guarantee of future results. U.S. equity income strategy shown represents the median fund by dividend yield within the Morningstar U.S. Equity Income category. Data from Dec. 2007 through Oct. 2017. Source: Morningstar, as of Oct. 31, 2017. 4
TRANSLATING FACTORS IN INTERNATIONAL MARKETS they are constructed. Factors can be defined in a number of ways, and there are many metrics that can be used to capture exposure to them. For example, value investors may examine earnings, sales, or cash flows to judge whether a stock appears inexpensive, and performance can vary based on which metric is used. Another key consideration is whether the strategy controls for unintended or incidental exposures, which could influence the strategy s risk/return profile and dampen the effects of the desired factor. For U.S. factor strategies, restricting sector over- and underweights is helpful to allow for pure factor exposures. Beyond sectors, investing in international markets raises a host of new potential unintended risks, including overexposure to individual countries and regions. These geographic overweights make a portfolio more vulnerable to economic downturns or currency depreciation in those parts of the world. And for investors seeking international dividends, greater country concentration in a portfolio may worsen the impact of withholding taxes that some countries deduct on dividends paid to U.S. residents, which may reduce net yields. By controlling for unintended exposures and neutralizing those risks, the desired factor will drive more of the factor strategy s risk/return profile. Exhibit 7 illustrates the risk drivers of two approaches to international value investing a traditional style index and a value factor portfolio. Because traditional style indexes do not generally control for unintended risks, much of the risk/ return profile is driven by country and currency exposure. But the constrained factor value strategy can limit those exposures; therefore, stock selection and exposure to the value factor are the predominant drivers of risk. EXHIBIT 7: By controlling for incidental exposures, such as sector, country, and currency risks, an international value factor strategy s risk/return profile will be driven mostly by the value factor itself. Analysis of Risk Drivers International Value Factor International Value Style Index 9% 19% 17% 4% 70% 25% 49% Factor Exposure & Stock Selection Country Allocation Sector Allocation Currency Allocation 7% The international value factor strategy shown is sector and country neutral. Analysis of variance (ANOVA) from 1986 through 2015. Source: FactSet, as of Dec. 31, 2015. 5
Conclusion Factors have generally behaved similarly in international markets as they do in the U.S., and in some cases, their performance has been even more compelling. In other words, the reasons for incorporating international factor strategies within a portfolio may be similar to those for owning U.S. factor strategies for exposure to stocks with characteristics that drive risk and returns over time, or provide desired investment outcomes (such as income). Furthermore, U.S. investors are largely under allocated to international stocks in their portfolios. Factor-based approaches may, therefore, be compelling options for investors seeking the potential diversification benefits of international stock exposure. Authors Darby Nielson, CFA l Managing Director of Research, Equity and High Income Darby Nielson is managing director of quantitative and technical research for the Equity and High Income division of Fidelity Investments. In this role, he leads a team of analysts conducting quantitative research in alpha generation and portfolio construction for Fidelity s equity and high income funds, along with a team of analysts providing technical research recommendations to the division s portfolio managers. Bobby Barnes l Quantitative Analyst, Equity and High Income Bobby Barnes is a quantitative analyst at Fidelity Investments. In this role, he is responsible for conducting alpha research to generate stock ideas and for advising portfolio managers on portfolio construction techniques to manage risk. Paul Baiocchi, CFA l Vice President, Sector and ETF Investment Strategy Paul Baiocchi is vice president of sector and ETF investment strategy at Fidelity Institutional Asset Management, Fidelity Investments distribution and client service organization dedicated to meeting the needs of consultants and institutional investors. He is responsible for supporting the distribution efforts for Fidelity ETFs and mutual funds across Fidelity s distribution channels. Additionally, he works with internal and external partners to increase product visibility, leveraging Fidelity resources to increase awareness of sector and ETF investing. Fidelity Thought Leadership Vice President Christie Myers provided editorial direction for this article. 6
TRANSLATING FACTORS IN INTERNATIONAL MARKETS Appendix All factor portfolio returns shown are equal-weighted and sector neutral, assume the reinvestment of dividends, and exclude fees and other implementation costs. Size (small-cap) returns are yearly returns of the equal-weighted bottom quintile (by market capitalization) of the MSCI World ex. U.S. and Russell 1000 Indexes. Value composite returns shown are yearly returns of a combined average ranking of stocks in the top quintile by book/price ratio and by earnings yield of the equalweighted MSCI World ex. U.S. Index and Russell 1000 Indexes. Momentum returns are yearly returns of the equal-weighted top quintile (by trailing 12-month returns) of the MSCI World ex. U.S. and Russell 1000 Indexes. Quality returns are yearly returns of the equal-weighted top quintile (by return on equity) of the MSCI World ex. U.S. and Russell 1000 Indexes. Return on equity is a measure of profitability that calculates how many dollars of profit a company generates with each dollar of shareholders equity. Low-volatility returns are yearly returns of the equal-weighted bottom quintile (by standard deviation of weekly price returns) of the MSCI World ex. U.S. and Russell 1000 Indexes. Standard deviation is a measure of return dispersion. A portfolio with a lower standard deviation exhibits less return volatility. Dividend yield returns are yearly returns of the equal-weighted top quintile (by dividend yield) of the MSCI World ex. U.S. and Russell 1000 Indexes. Unless otherwise disclosed to you, any investment or management recommendation in this document is not meant to be impartial investment advice or advice in a fiduciary capacity, is intended to be educational and is not tailored to the investment needs of any specific individual. Fidelity and its representatives may have a financial interest in any investment alternatives or transactions described in this document. Fidelity receives compensation from Fidelity funds and products, certain third-party funds and products, and certain investment services. The compensation that is received, either directly or indirectly, by Fidelity may vary based on such funds, products and services, which can create a conflict of interest for Fidelity and its representatives. Fiduciaries are solely responsible for exercising independent judgment in evaluating any transaction(s) and are assumed to be capable of evaluating investment risks independently, both in general and with regard to particular transactions and investment strategies. Information presented herein is for discussion and illustrative purposes only and is not a recommendation or an offer or solicitation to buy or sell any securities. Views expressed are as of the date indicated, based on the information available at that time, and may change based on market and other conditions. Unless otherwise noted, the opinions provided are those of the author and not necessarily those of Fidelity Investments or its affiliates. Fidelity does not assume any duty to update any of the information. Investment decisions should be based on an individual s own goals, time horizon, and tolerance for risk. Nothing in this content should be considered to be legal or tax advice and you are encouraged to consult your own lawyer, accountant, or other advisor before making any financial decision. Stock markets, especially non-u.s. markets, are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks, all of which are magnified in emerging markets. Investing involves risk, including risk of loss. Past performance is no guarantee of future results. Diversification and asset allocation do not ensure a profit or guarantee against loss. All indices are unmanaged. You cannot invest directly in an index. Index definitions The Russell 1000 Index is a market capitalization-weighted index designed to measure the performance of the large-cap segment of the U.S. equity market. The MSCI World ex US Index is a market capitalization-weighted index designed to measure the investable equity market performance for global investors of large-cap stocks in developed markets, excluding the United States. Third-party marks are the property of their respective owners; all other marks are the property of FMR LLC. The Chartered Financial Analyst (CFA) designation is offered by the CFA Institute. To obtain the CFA charter, candidates must pass three exams demonstrating their competence, integrity, and extensive knowledge in accounting, ethical and professional standards, economics, portfolio management, and security analysis, and must also have at least four years of qualifying work experience, among other requirements. If receiving this piece through your relationship with Fidelity Institutional Asset ManagementSM (FIAM), this publication may be provided by Fidelity Investments Institutional Services Company, Inc., Fidelity Institutional Asset Management Trust Company, or FIAM LLC, depending on your relationship. If receiving this piece through your relationship with Fidelity Personal & Workplace Investing (PWI) or Fidelity Family Office Services (FFOS), this publication is provided through Fidelity Brokerage Services LLC, Member NYSE, SIPC. If receiving this piece through your relationship with Fidelity Clearing & Custody Solutions or Fidelity Capital Markets, this publication is for institutional investor or investment professional use only. Clearing, custody, or other brokerage services are provided through National Financial Services LLC or Fidelity Brokerage Services LLC, Members NYSE, SIPC. 7
2018 FMR LLC. All rights reserved. 825806.1.0