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Factor Investing is Smart Investing

Jun. 09, 2016

Jun. 09, 2016

With increasingly volatile equity markets, stretched valuations and the length of the bull market, investors are naturally nervous and cautious, as they have been for more than seven years. But for many investors equity markets are still a rewarding place to be provided that they offer diversification and uncorrelated returns.

With that in mind, STOXX developed, in collaboration with the independent asset management boutique, Alpha Centauri, the suite of iSTOXX® Europe Single and Multi-Factor Index products. These factor indices offer exposure to six key sources of systematic risk and potential return; value, carry, momentum, size, low risk and quality. The index suite allows investors to choose a specific single factor to invest in, as well as dynamically combine them in a “multi-factor” blend.

What links these factors is that they are all identifiable sources of returns. Of course, there are other factors which can explain returns, but these are the most distinct ones. The indices allow investors to capture the premia related to the factors while simultaneously minimizing other systematic sources of risk.

The iSTOXX® Europe Single and Multi-Factor Indices are constructed from the STOXX® Europe TMI, and measured against the STOXX® Europe 600 index, which accounts for 95% of the total investable European universe in market-capitalization terms. Each stock is scored on the basis of the number of underlying and equally-weighted measures, relevant to each factor. The final selection and weightings are calculated by an optimizer that maximizes the exposure to a factor while applying a set of constraints, including liquidity and tracking error.

The chart below shows the returns of each factor relative to the benchmark over almost twelve years. What is immediately evident is that the six factors have all outperformed the benchmark over the time period, albeit in varying degrees. Momentum has been the best performing factor while low risk brings up the rear, although still ahead of benchmark. Some factors have been quite volatile over the period, which is a reminder that not all factors outperform all of the time.

Chart 1: Chart to show the returns of each factor relative to the benchmark

Source: STOXX

An additional comfort for the investor seeking diversification and uncorrelated returns is that the single-factor indices are almost entirely uncorrelated, or negatively correlated, with the STOXX® Europe 600 benchmark. Additionally, the correlations between the separate factors is low.

For the investor who would like exposure to all the six factors, all shown to provide positive relative returns, there is the iSTOXX® Europe Multi-Factor index.  This index includes companies that score well across all of the factors; the names included are not just a simple amalgamation of all the best-scoring stocks in each of the single factor indices. The optimization technique selects stocks that score well on all six factors.

As the chart below shows, the iSTOXX® Europe Multi-Factor Index outperformed both a simple equally-weighted factors index and the STOXX Europe 600 index over the ten years to December 2015. It also outperformed the equally-weighted version in every single year. It is clear from this that a dynamic combination of stocks scoring well across a range of factors outperforms a simple equally-weighted version of the factors.

Chart 2: Chart to show the performance of the iSTOXX® Europe Multi-Factor Index

Source: STOXX

What the discussion and charts above demonstrate, is that a strategy which combines a simple product such as the STOXX® Europe 600 with the iSTOXX® Europe Single or Multi-Factor Indices will provide diversified and uncorrelated exposure to the market, with the factor indices providing superior returns over the long run.

 

 

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