As a pioneer of factor investing, Robeco’s latest contribution to the debate on how it works was to conduct a study on how investors apply factor investing to their equity portfolios in practice. The study found that the Value, Momentum and Low-Volatility premiums have been particularly large and robust over time, and over different markets. Even when using more conservative expected returns for the future, the study still found that the optimal allocation to these premiums should be sizable.
Moreover, allocation to factor premiums should be diversified (where a simple equal-weighted approach already seems to be quite efficient) and determined strategically in order to avoid chasing recently winning styles. The study revisited this recommendation by using five years of new data and also incorporating the Quality factor. It showed that in ‘out-of-sample’ data, such a factor investing strategy continued to add value. Interestingly, similar factor premiums also appear to be present in other asset classes, such as bonds and commodities.
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The Quality premium
The quality effect is the tendency of high-quality stocks to outperform low-quality stocks and the market as a whole. What sets the Quality factor apart from the other factors is that the concept of ‘quality’ is less well defined than these other factors. For instance, even though Value can be defined using different measures, the consensus is that a stock is considered cheap if the market price is low relative to a fundamental measure. The Low-Volatility effect relates to the premium prevalent for low-risk stocks. High-quality companies typically are considered to be highly profitable, have high earnings quality, and/or are conservatively managed. Other stock characteristics that are linked to the Quality premium include safety and growth. Hence, ‘quality’ has a very broad meaning and as a result is much vaguer than the other factor definitions.
A potential issue with this vague factor definition is that the term quality can be misused or even abused. For instance, Robeco research shows that safety, measured by financial leverage, earnings stability, low credit risk and sometimes even return-based metrics such as market beta and volatility is actually a very different factor on its own, essentially becoming the low-volatility (or low-risk) factor.
And secondly, the research reveals that other quality definitions have weak or sometimes even non-existent (standalone) predictive powers for future returns, as is the case for growth measures such as rising profitability, but also an often-used measure like return on equity (ROE). Robeco’s concerns with existing generic Quality strategies is that these are suboptimal due to the use of poor definitions which are sometimes even mixed with other factors to boost their (back-tested) performance. This approach does not result in achieving efficient exposure to the Quality factor to capture the quality premium.
Strong evidence for Quality factor
This research on the quality factor resulted in a multi-dimensional view on ‘quality’ that incorporates profitability, earnings strength and management policy. Each of these three themes has a deeply rooted academic underpinning, and is shown to have a strong standalone performance. Robeco therefore believes that a sophisticated approach to quality investing will result in a positive and robust return premium.
Meanwhile, a vast amount of studies have attempted to validate or falsify the existence of the Value, Momentum and Low-Volatility premiums. For the ‘newer’ Quality factor premium the evidence is strong, but it has been put to the test less frequently than the other factors. As such, Robeco is positive on the Quality factor but would start with a lower weight to this factor.