Who hasn’t heard “sell in May and go away”? The market adage is as old as the hills. But it keeps cropping up because by and large, it’s tended to work. Over the long run, in liquid, mature equity markets like the US and UK, investors have generally improved their returns by reducing their allocation to stocks during the summer months and increasing it from around Halloween.
This seasonal effect is a basic example of an investment factor – specific attributes shared by groups of assets that have historically had a material impact on investment performance. Some, like “sell in May”, are simple rules that have persisted for many decades. Others, such as the tendency for smaller cap stocks to deliver stronger returns over the long run, are more cyclical and complex.
Over the past 50 years, a large volume of academic work has sought to identify factors that can reliably be harnessed by investors. In effect, factors are market anomalies that contradict the efficient market hypothesis, which argues that all relevant information is reflected in asset prices.
Yet while factors may be the preserve of professional investors, understanding why they exist can provide useful insights into market inefficiencies, investor psychology and portfolio construction.
Some factors, for example, owe their existence to investors’ behavioural biases – such as loss aversion or self-perpetuating faddishness. Others, meanwhile, hold only during certain stages of a business cycle. Some are arbitraged away almost as soon as they’re identified and others exist because of the regulatory constraints certain investors are subject to – such as having to match liabilities with low-risk assets.
A universe of factors
The range of factors is broad. Take calendar effects, where the “sell in May…” rule is only one of a number of seasonal factors. There’s also the Santa Claus rally, where equities tend to surge in the week after Christmas and into the start of the new year, not to mention quarter-end and turn-of-month effects that have variously been identified. (Swinkels, L., van Vliet, P. “An Anatomy of Calendar Effects,” Journal of Asset Management 13(4), 2012 pp. 271-286)
Investment professionals, however, tend most often to focus on five key factors [see chart above for examples].
Size: in the early 1980s, Rolf Banz, long associated with Pictet Asset Management, analysed and described a relationship between companies’ market capitalisations and their risk adjusted returns. Over time, he found that smaller companies tended to outperform. This may be down to liquidity effects – investors demand more premium from shares that, potentially, they can’t easily sell. Or it may be down to the fact that smaller companies are less researched, creating inefficiency that investors can take advantage of.
Valuation: companies whose shares trade on lower price-to-earnings multiples, or price-to-book ratios, tend to outperform over the very long run. One argument for this is that over shorter periods market noise can mask firm's intrinsic value, but that eventually shares will revert to the correct price. However, this sort of mis-pricing can last a long time. In the 10 years since the global financial crisis, growth stocks have outpaced their value equivalents. It could take a recession for this to reverse. (“There’s still only one winner in the growth versus value fight,” Financial Times 20.10.2018)
Momentum: the tendency for stocks that are enjoying a strong run to continue this into the future. Under a momentum strategy, investors increase their allocation to stocks or bonds that have been rising in price, and cut holdings of those that are dropping. Momentum has historically tended to be a particularly effective investment approach, though getting caught out on big market turning points can be painful.
Quality: companies with strong profit margins and significant market share tend to outperform over the long run. Quality is similar to valuation, and has similar drawbacks. Stock markets can under-appreciate good quality companies for uncomfortably long stretches.
Volatility: portfolios composed of stocks that are less volatile than average tend to generate better returns over time than those composed of shares that see big price swings. Generally, investors would expect to be compensated for risk – for which volatility is a proxy. Evidence, however, suggests the opposite.
The benefits of diversity
Some factors only become apparent after considerable data crunching. Quantitative strategists often analyse hundreds of millions of data points across tens of thousands of data series ranging across market prices, government statistics and private sector surveys to identify a source of additional returns. Some of these factors will then only work for a short time before the entire market catches on.
By identifying factors and exploiting them appropriately, investors can boost their returns above the market average. Equity factors can also serve as portfolio building blocks.
An equity portfolio that deliberately splits investments across say, value, growth and low volatility stocks can be as diversified as one that invests by region or by country. That's because 'value', 'growth' and 'low volatility' stocks outperform during different phases of the economic cycle.
But as with all aspects of investing, factors aren't failsafe. Some are dependent on the investment time horizon and can contradict each other over a given period – for instance a company with an attractive valuation can grow even cheaper if momentum happens to be holding sway. Others hold on average over many cycles but don’t during shorter spans. Some factors work for a time but then fade as they become adopted widely.
Understanding why some factors have persisted historically is crucial for investors seeking to apply these strategies. So too is being able to assess how popular such trades have become when implementing factor approaches. Meanwhile, some factors only exist on paper, as a result of heavy data mining and back testing.
What is clear is that factors of one sort or another are likely to be cited and used by investors as long as markets continue to exist.