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Factor investors should be patient and brave

Factor investors should be patient and brave

05-09-2019 | インタビュー

What’s best, quantitative or fundamental? And, which are the main factors investors should consider in their portfolios? Here are some the topics we discussed with our guest Marc-Gregor Czaja,1 from Allianz Investment Management.

  • Yann Morell Y Alcover
    Yann
    Morell Y Alcover
    Investment Writer

Speed read

  • To some extent, fundamental and quant investors tap the same sources of return
  • Investors should be aware of their exposures, even if they don’t do explicit factor investing
  • Investors must bear in mind that factors do not materialize steadily over time

Marc-Gregor Czaja

Global Head of Equities and Derivatives at Allianz Investment Management, in Munich

How do you view the rise of pure quant investing? How does quant fit with more traditional fundamental investing?

“Honestly, at Allianz we are pretty agnostic regarding the question of fundamental versus quantitative. We do both, which implies that we don’t think one is necessarily better than the other. It depends. What’s more, I think that, to a large extent, fundamental and quantitative investors tap the same sources of return.”

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OK. But what does it depend on?

“I think the most important element has to do with how far away you want to position yourself from the benchmark. If you have little appetite for relative risk, then quantitative strategies are probably more suitable. But if you are interested in very active strategies that really break away from any benchmark and require a flexible investment process, then you will probably feel more comfortable with a fundamental manager.”

You say a quantitative approach is more suitable if you want to stay close to the benchmark. Is that because fundamental strategies cannot continuously screen the entire investable universe and tend to focus on just a subset?

“Yes. But I think there’s another aspect: portfolio construction. The closer to the benchmark you want to be, the more important your portfolio construction is. That involves quantitative techniques, which is something the typical quantitative manager is better at. I often say that, to a certain extent, quants are better portfolio constructors.”

Because they are more systematic, right?

“Exactly. They are probably better at understanding short-term drivers of diversification. But there’s a catch. When market fundamentals break down completely, when there’s a regime shift, when the past does not tell you anything about the future, then a skilled and seasoned fundamental manager may have an edge; although that’s obviously a rare skill.”

In the particular case of factor investing, how do you think investors should consider it in a broad portfolio?

“I tend to look at this from a slightly higher level: factors are very important return drivers whether you adopt a quantitative or a fundamental approach. Again, both types of strategies tap the same sources of return, at least to some extent.”

Do you mean that you can do factor investing with a fundamental approach?

“Yes. For instance, there was a recent paper explaining Warren Buffet’s performance based on the value and quality factors.2 And Warren Buffet is not the first person you would think of as being a quant investor. This implies that you should be aware of your factor exposures, whether you do explicit factor investing or not. You should know which sources of return you are exposed to and how well diversified these exposures are. I think of factors as a tool to improve diversification.”

Which proven factors should investors focus on, in your view?

“My views on this are pretty consensual. Investors should consider value, momentum, small caps, and to a less extent, quality and low risk. But what investors should really figure out – particularly because my list is so consensual – are the reasons behind the performance of a particular factor and how well all this fits with their investment needs and beliefs.”

I don’t think factor performance can be timed in the short term

In this case, you mean in the short-term performance?

“No, I mean medium to long-term justifications as to why these factors should be priced in. I don’t think factor performance can be timed in the short term.”

Which factor strategies are appealing for an insurance company like Allianz? Are there any factors that you prefer?

“There are indeed factors we prefer to others. Generally speaking, our business is very long term with very long-dated liabilities, at least as regards life-insurance. This means we tend to have time on our side and therefore sell liquidity, if you will. So, any factor that involves selling liquidity, like small-cap investing, is interesting for us. Value is also something that works for us, simply because at the end of the day, it pays to buy cheap. You simply need time for a catchup to take place.”

“Having said that, we are not a long-only, but a liability-driven investor. We need some downside protection, we need to control drawdowns, and value and small-cap investing can be cyclical. So, we also like factors that outperform or protect from drawdowns when markets tank, as diversifying factors. I am talking here about quality and, to a lower extent, low risk.”

“Finally, something that typically does not work for us is momentum. Momentum strategies usually involve relatively high turnover and we are quite wary of turnover for a variety of reasons. Transaction costs is one, stability of accounting returns is another.”

Because the performance of these strategies can be erratic, right?

“Exactly. Generally speaking, I like this kind of strategy a lot. I myself worked quite a bit on momentum investing, in earlier days. I even published a couple of papers on this topic.3 So, I don’t mean momentum is not interesting or does not work. But for an investor like Allianz, this is not the best type of strategy.”

Some factors, in particular value, have recently been through a rougher patch, which seems to have cooled some of the enthusiasm shown by investors over the past few years. What is your take on this?

“This is precisely what I meant when I said investors should figure out the reasons behind the long-term performance of a particular factor and how well they fit with their investment needs and beliefs. Some people thought that factor investing was an easy way to make money and now realize it isn’t. Of course, it was never meant to be. Many factors are, at the end of the day, risk premiums. And risk premiums do not necessarily materialize steadily over time. They are often cyclical.”

“This is especially true for the value factor. Value has been through a rough patch for most of the post-financial crisis period, and 2018 was particularly challenging. But that’s not something new. Value did not perform for most of the 1990s. There were short periods of relief, like in 1994 as the Fed tightened its monetary policy. But overall, investors did not make much money with the value factor during the decade.” 

“There were also long periods when investors did make money with value. And there is overwhelming empirical evidence to show that value has performed over long periods of time. So, I am not overly worried. This is just something investors need to understand.”

You said you did not believe in tactical factor timing. But how should investors consider factor investing throughout market cycles?

“First and foremost, factor investors should be patient and brave. Some people claim they can time factors, but the evidence I am aware of is not particularly strong. That being said, we do look at valuations. Valuations are not a good market-timing tool, but over the medium to long term, they are probably the best predictor. Right now, value is very cheap, while more defensive styles such as low risk and quality are relatively expensive. So, you should certainly take this into account for your factor allocation. But I would not call that timing. It’s more strategic positioning, if you will.”

Do you mean tilting portfolios? Going passive?

“No. I am not talking about binary decisions such as active vs. passive. It is about tilting the portfolio allocation but not based on short-term views. You first need to understand which factors you want to be exposed to. Then, when we invest fresh money or when we have a large re-allocation, the valuation of factors is one input for the investment decision. But we are not chasing factor performance.”

This article was initially Published in our Quant Quarterly magazine. 

1Marc-Gregor Czaja is Global Head of Equities and Derivatives at Allianz Investment Management, in Munich. He holds a PhD in Finance and a master’s in Business Administration from the Catholic University of Eichstätt-Ingolstadt and the Chartered Financial Analyst designation. His research has been published in several journals, including The Quarterly Review of Economics and Finance and European Financial Management.
2Frazzini, A., Kabiller, D and Pedersen, L. H., ‘Buffett’s Alpha’, Financial Analyst’s Journal 74 (4), 35-55.
3Czaja, M.-G., Kaufmann, P. and Scholz, H., ‘Enhancing the Profitability of Earnings Momentum Strategies: The Role of Price Momentum, Information Diffusion and Earnings Uncertainty’, Journal of Investment Strategies 2 (4), 3-57, and Bohl M., Czaja, M.-G. and Kaufmann, P., ‘Momentum Profits, Market Cycles, and Rebounds: Evidence from Germany’, Quarterly Review of Economics and Finance 61, 139-159.

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