Most quant or factor-based equity strategies have exposure to the value factor. Value investing is the best-known and oldest investment style, and the value premium has been documented in numerous academic studies. We view attractively valued stocks as typically those of mature companies in traditional business sectors that are less popular among investors. Although we have seen that value stocks have historically outperformed growth stocks, the experience in recent years has been completely different: the incredible returns generated by a handful of very large growth companies in the technology sector have dominated the market’s average return and boosted stock market indices to all-time highs.
To illustrate, the cumulative total return of the FAANG stocks1 over the last five years was a staggering 280%, compared to 78% for the broad MSCI World Index, which would have been 11 percentage points lower without the FAANG stocks. From a valuation perspective, big tech stocks were unattractive as they were trading at expensive multiples such as the traditional price-to-book ratio. They were therefore not selected in value portfolios. Portfolios without big tech stocks clearly lagged their benchmarks, and so did most quant equity strategies that employed the value factor in their investment process. Outperforming equity factors like profitability and momentum failed to offset the losses of the value factor2.
Due to the extreme rally of big tech stocks, the weight of the technology sector in the MSCI World index also grew rapidly, from 14% at the end of 2015 to 22% at the end of 2020, amplifying their dominance in equity index returns. In short, tech stocks were already big and expensive in 2015, but due to their strong performance they only got bigger and more expensive over the past few years.
By contrast, the returns of big tech firms had much less of an impact on credit index returns. This is not only because the bond returns were much lower than the equity returns, but also because the weight of these firms in the credit index was much smaller. Big tech firms did not issue a lot of bonds as they could more cheaply finance their acquisitions with stocks or cash. To illustrate, the total weight of Apple, Microsoft, Amazon, Facebook, Alphabet and Tesla in the credit market is only 1.5%, while these six companies represent almost 15% of the global equity market.
We see that value in equities struggled, mainly due to missing out on the staggering returns of big tech companies, and that big tech did not dominate in terms of returns and market weight in credits. So how did value perform in credits?
Remarkably, value was the best-performing factor in the credit market over the past five years compared to other well-known factors such as low-risk, quality, momentum and size. How can the strong performance of value in credits be explained? In short, value prefers bonds that are attractively priced and thus have above-average credit spreads compared to other bonds with the same risk profile. Such bonds generally perform strongest when credit markets compress and deliver positive credit returns, while the low-risk factor does better when credit returns are negative, as it prefers bonds and issuers that are safer than average. In recent years, credit markets generally posted positive credit returns, supported by the ongoing search for yield and central bank corporate bond buying programs. In this environment, we have seen value perform strongly.
In terms of the value factor’s preferences in the credit market, we find that it actually had a modest preference for the technology sector on average over the last five years. So, bonds from tech firms on average carried somewhat attractive risk premiums given their credit risk and given the credit spreads of similarly risky bonds. This contrasts sharply with the unattractive valuations of tech firms in the equity market and the underweight in many quant equity strategies. Robeco’s Multi-Factor Credits strategy did have overweight positions in tech companies. Next to the somewhat attractive valuations, the overweights were mainly driven by the low-risk/quality and momentum factors that appreciated their characteristics of – on average – solid balance sheets, attractive profitability and strong equity market momentum. The divergent relative performance of multi-factor portfolios in equities and credits is not a surprise. Previous research shows that the two only have a 17% correlation.
1The weighted average total return in USD of a group of big tech firms: Facebook, Apple, Amazon, Netflix and Alphabet (Google) over the period January 2016 to December 2020.
2For more insights we refer to the article “The quant equity crisis of 2018-2020: Cornered by big growth” by David Blitz, published in February 2021.