Style Investing
As the concepts of risk and expectations of returns have become much more complex elements in the investment cocktail of science and art, the endeavor of building the perfect portfolio has become a paramount step for most sophisticated investors.
We now understand the relationship between risk and return is not as linear as expected because of different and multiple sensitivities of assets to economic variables and structural contingencies. A classic example of the unstable relationship between risk and return is represented by the long periods of bonds outperformance over equities in the last fifteen years. Contingencies such as unexpected counterparty risk and extraordinary monetary policy altered the assets sensitivities over these long stretches.
If we had a crystal ball, we would regularly anticipate economic variables interactions and we would always be perfectly allocated. However, in real life, we can only make informed projections based on historical analysis and ex-ante valuation metrics (or in layman terms, metrics of judgment that are likely to be more forward looking than rear-view biased) and scale our portfolios accordingly but high uncertainty in future developments will ultimately be “the only certainty.”
Early portfolio construction practices usually revolved around the two major asset classes, stocks and bonds, with the mix often dictated by personal preferences or investor’s age. However, over the years, the powerful impact of smart diversification became evident in most successful portfolios and institutions. The Endowment model popularized by Harvard and Yale indicated the way toward a method built around high diversification of asset classes and strategies or styles.
The rise of style investing was the result of the obvious recurrent anomalies that could not be explained by pure beta (or passive returns associated with an asset class) and that were too periodic to fall under alpha (or skill based returns). After much research, it appeared that markets could offer extra returns when such anomalies were implemented in a systematic way. The classic styles so far recognized are: value, momentum carry and trend following (closely related to momentum). These anomalies have shown to usually work in cross-sectional studies and not only in specific geographic markets and or assets.
A recent study by Ilmanen, Maloney and Ross, analyzed major global asset classes (equities, bonds, commodities) and the above mentioned styles and looked at their sensitivities to a number of macroeconomic variables. The two main variables investigated – growth and inflation - are thought to be the two most important drivers of financial asset performance. Ilmanen et al. also looked at sensitivities to real yields, volatility and illiquidity levels.
In order to test the validity of the underlying idea that style diversified portfolios may be more solid than less diversified ones, they also analyzed hypothetical portfolios under different economic conditions.
The different portfolios tested included the following:
- Global stocks as represented by the MSCI World Index USD denominated
- Global bonds as a GDP weighted composite of six 10 year government bonds
- Commodities as an equal dollar weighted composite of 24 commodities
- Value represented by a strategy that buys assets which are cheap relative to fundamental value and shorts expensive assets
- Momentum as a strategy that buys assets recently outperforming peers and shorts those that lagged
- Carry as a strategy that buys high yielding assets and shorts low yielding ones
- Defensive where the strategy buys low risk, high quality assets and shorts speculative ones
- Trend following or a strategy that buys assets with recent price rise and sells those with price reductions.
The study’s conclusions validated that the traditional asset classes – stocks, bonds and commodities – were indeed more sensitive to macro risks than style strategies. Unsurprisingly, equity favored economic contingencies marked by growth, bonds favored deflation and commodities inflation. When looking at a combination of growth and inflation, the patterns of sensitivity seemed even more pronounced and again unsurprisingly, the combination of high inflation and low growth seemed unfavorable to all three asset classes.
On the other hand, the five style strategies in the study delivered positive Sharpe ratios in all growth and inflation environments. Moving beyond inflation and growth, the study looked at sensitivity to volatility, real yields and liquidity conditions. Momentum seemed to experience the greatest correlation to these macro risks. Higher volatility and low liquidity environments generally hurt across the board but in terms of growth, inflation and real yields, style strategies seemed to clearly outperform. All considered, Sharpe ratios for all styles were positive, regardless of the risk contingency.
These findings carry significant implications in terms of portfolio construction. If traditional asset classes alone carry more macro risk than diversified styles, it becomes evident that building portfolios that utilize traditional blocks and also include style premia should result in more stable long term performance in spite of macroeconomic backgrounds.
The Ilmanen study finds that combining multiple long/short styles with traditional asset classes produces stable performance whether growth or inflation (and any combination of the two) were up or down. Similar findings were true for real yield contingencies while volatilities and illiquidity risks were more damaging.
This study validates our long standing view that strategically built portfolios should be highly diversified not only in terms of asset classes but also in terms of style or factors. “Smart diversification” as we call it is one of the pillars of our portfolio construction process based on the Endowment Investing Model.
Sources:
Ilmanen, Antti, Thomas Maloney, Adrienne Ross, “Exploring Macroeconomic Sensitivities: How Investments Respond to Different Economic Environments,” Spring 2014, The Journal of Portfolio Management, Volume 40, Number 3
Moskowitz, Toby, “Investing with Style: The Case for Style Investing,” January 14 2014, AQR