united kingdomen
Some factors are now more equal than others

Some factors are now more equal than others

06-10-2021 | 5-Year outlook
There is no free lunch when it comes to harvesting factor premiums. In fact, there are sustained periods in which one or more factors experience negative returns, says quant researcher Laurens Swinkels.
  • Laurens Swinkels
    Laurens
    Swinkels
    Researcher

Speed read

  • The value, quality, low-risk and size factors perform differently
  • Value has been cheap recently and is now making a comeback
  • Macro environment and climate risk also play a role in five-year outlooks 

Some investors have strong hands during such downturns, enabling them to benefit from the upswings, while others may try to dynamically allocate to factors. Our research shows that over a five-year horizon, value is currently the most attractive factor.

The considerable variation in the rolling five-year returns of value, quality, low risk and size for the US equity market can be seen in the chart below, using data going back to 1968. 

 5-year Expected Returns
5-year Expected Returns
Digital event: Thursday 7 October 2021, 16:00 CET/10:00 EDT/15:00 BST
Register now!
Annualized US factor returns for size, value, quality and low risk over five-year periods. Source: Robeco, Kenneth French data library, Paradox Investing.
While these cycles can be observed in hindsight, the question is whether we can predict them beforehand. We try to do so using the methodology we developed for our five-year forecasts for asset classes in Expected Returns. This is done in four steps, looking at long-term premiums, valuation ratios, the macroeconomic environment, and climate risk.

1. Long-term premiums

The long-term factor premiums, excluding costs and fees, can be seen in the table below. 

Size: The long-term outperformance of small cap stocks relative to their large cap counterparts (the ‘size effect’) is positive, at 2.49%. However, the market risk-adjusted return (the alpha) of 0.91% is not statistically different from zero, as its t-statistic is below the threshold of two. 

Long-term global factor performances. Source: Robeco, Kenneth French data library, Paradox Investing.

Value: The raw outperformance of high book-to-market stocks relative to their low counterparts is strong at 4.03%. while its alpha is 2.75% per year. The value premium is also strong for the post-1963 period, despite the insignificant alpha of 2.14% since 1990 in the US. 

Low risk: This factor’s premium has been one of the strongest in history, with a long-run average return of 5.99%. This is close to its alpha by design, as the factor becomes neutral to market risk by leveraging up the low-risk portfolio and leveraging down the high-risk portfolio. 

An important question is whether these historical premiums will persist in the future. We believe they will, based on three convincing explanations. The first is that they are the reward for bearing systematic risk; the bad news is that factor investing then is risky, but the good news is that the premiums are persistent. 

The second is institutional: the way the finance industry is organized, including its regulation, may give rise to incentives that are inconsistent with traditional finance. For example, capital requirements in solvency regulation are not dependent on the risk of the equity portfolio, which may lead to a low-risk premium. 

The third relates to behavior, in that investors use signals, heuristics or preferences that are inconsistent with rational behavior. Based on the assumption that fear and greed are hardwired in investor behavior, this leads to persistent factor premiums. 

However, if all these explanations no longer hold going forward, we are open to reconsidering the existence of these premiums.

Expected Returns 2022-2026
Expected Returns 2022-2026
Our new 5-year outlook
Read all articles

2. Valuation ratios

The second step is to find indicators of an asset class being cheap or expensive. Valuation indicators, for example, have been found to have predictive power for returns. Research shows that when factor premiums are cheap, returns tend to be high in the five years that follow – a pattern that is particularly visible for value and size. 

The chart below shows the time variation of the valuation signal for the four equity factors over time, where a measure above one indicates that the factor is cheap. Over the past two years, the value factor has been extremely cheap, peaking at even higher levels than previous highs, which were reached just before the dot-com bubble burst. 

Based on the current readings of these valuation spreads, we expect higher returns for value, low risk, and quality, and average returns for size.

Valuation spreads of global equity factor premiums. Source: Robeco.

3. The macroeconomic environment

The third step is to consider the macroeconomic environment and the stage that the business cycle is in: expansion, slowdown, recession and recovery. The reading from June 2021 forecasts an expansion as the world emerges from the Covid-19 pandemic.
The business cycle reading at June 2021: an expansion phase. Source: Robeco. Van Vliet and Blitz (2011).

Research shows that following expansionary signals, the size and quality factors tend to perform poorly, while the value factor is relatively strong. Low risk is the strongest factor during recoveries.

There is a popular belief that value factor returns correlate negatively with bond returns. While this may have been the case over the past couple of years, research show that the relationship between value and interest rates over the long run is virtually zero. The size factor has a significant negative relationship, and the low-risk factor a positive one.

4. Climate risk

The final ingredient is embedded climate risks. This looks at the carbon exposure of the generic size, value, quality and low-risk factors alongside that of the market index. Value and quality are currently the factors most exposed to climate risk, while size is close to the index, and low risk is substantially less exposed.

This leads to a negative climate tilt for the generic value and quality factors, and a positive tilt for low risk. Such tilts for generic value and quality can though be eliminated through strategy enhancements, which we implement for many of our clients.

The carbon exposure of generic global factors. Source: Robeco.

Five-year forecasts

In summary, we expect the value factor to do best over the next five years, returning 6.25% over the 2022-2026 period, with an alpha of 2.00%. We view the size factor as returning the least, 5.00% with an alpha of zero. Our full set of predictions are shown in the table below.
Expected equity factor returns for the five years under review in Expected Returns. Source: Robeco.

This article is an excerpt of a special topic in our five-year outlook.

Read the full Expected Returns 2022-2026 here.
Logo

Disclaimer

Please read this important information before proceeding further. It contains legal and regulatory notices relevant to the information contained on this website.

The information contained in the Website is NOT FOR RETAIL CLIENTS - The information contained in the Website is solely intended for professional investors, defined as investors which (1) qualify as professional clients within the meaning of the Markets in Financial Instruments Directive (MiFID), (2) have requested to be treated as professional clients within the meaning of the MiFID or (3) are authorized to receive such information under any other applicable laws. The value of the investments may fluctuate. Past performance is no guarantee of future results. Investors may not get back the amount originally invested. Neither Robeco Institutional Asset Management B.V. nor any of its affiliates guarantees the performance or the future returns of any investments. If the currency in which the past performance is displayed differs from the currency of the country in which you reside, then you should be aware that due to exchange rate fluctuations the performance shown may increase or decrease if converted into your local currency.

In the UK, Robeco Institutional Asset Management B.V. (“ROBECO”) only markets its funds to institutional clients and professional investors. Private investors seeking information about ROBECO should visit our corporate website www.robeco.com or contact their financial adviser. ROBECO will not be liable for any damages or losses suffered by private investors accessing these areas.

In the UK, ROBECO Funds has marketing approval for the funds listed on this website, all of which are UCITS funds. ROBECO is authorized by the AFM and subject to limited regulation by the Financial Conduct Authority. Details about the extent of our regulation by the Financial Conduct Authority are available from us on request.

Many of the protections provided by the United Kingdom regulatory framework may not apply to investments in ROBECO Funds, including access to the Financial Services Compensation Scheme and the Financial Ombudsman Service. No representation, warranty or undertaking is given as to the accuracy or completeness of the information on this website.

If you are not an institutional client or professional investor you should therefore not proceed. By proceeding please note that we will be treating you as a professional client for regulatory purposes and you agree to be bound by our terms and conditions.

If you do not accept these terms and conditions, as well as the terms of use of the website, please do not continue to use or access any pages on this website.

I Disagree