By Lance Humphrey, CFA, Portfolio Manager of Global Multi-Assets
The term “smart beta” is being heard more and more in the stock investing world – in its broadest sense, it refers to an approach to passive investing that doesn’t focus on indexes weighted by market capitalization, such as the Standard & Poor’s 500.
But that broad definition begs the question, “If you don’t use a market-cap-weighted index, what do you use?” And that’s where the basic notion of smart beta opens into a range of alternative stock characteristics, also called “factors,” that over the long term have been successful in managing portfolio risk and/or enhancing returns.Various factors have different track records in terms of risk and return. In our factor-based investing, we focus on two in particular: value and momentum.
Value: The foundation of value investing is the idea that cheaper assets (i.e., low price-to-earnings or low price-to-book value) will on average outperform expensive in the long term. Value is typically pro-cyclical, meaning it has tended to perform well in periods of economic expansion.
Momentum: The momentum factor is the tendency of well-performing stocks to continue performing well in the near term. Momentum tends to benefit from continued trends in the market and economy.
Over the past four decades, stocks with value and momentum characteristics have on average posted higher annual returns than the overall market.
On the risk side, we believe value and momentum historically have tended to be a little riskier than the other factors, but combining them can help lower that risk. We believe the persistence of excess return and its robustness compensates us for taking on any incremental risk.
Persistence doesn’t mean a strategy based on value and momentum pays off every year – in any given year, either factor can significantly lag the broad-market indexes. Last year, U.S. value was a strong outperformer, but this year it has struggled as investors have focused their attention on growth-oriented stocks. As a result, the P/E ratios of growth stocks have continued to climb ever higher even as their earnings growth has slowed relative to value stocks.
We currently see the best value opportunities in emerging markets, where the valuation spread between value and growth stocks is even wider than in the U.S.
Economic growth is picking up in EMs, which stands to be a positive for beaten-up value stocks. And on the momentum side, history shows that once EM stocks pick up a tailwind, their outperformance often lasts for years.
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