In an interview with The Asset (TA), Priscilla Luk, global head for index research and design, Asia Pacific at S&P Dow Jones Indices, explains how factors perform across different economic cycles in China
TA: We know that smart beta strategies or factor investing can be useful for active strategies in equities markets, but before we go into the technicalities, can you just explain to us what is factor investing or smart beta investing?
Luk: Sure. Actually, smart beta and factor investing are pretty much the same as it’s trying to capture the market with different exposures compared to the broad market index.
For example, some of the factor indices try to capture different factors like value, quality and momentum. The way to capture that is the index might create a different stock selection with different weighting so that it captures the factor with different characteristics.
For example, in an up and down market they may have different performance, different sector exposure, and different factor exposure. But most of the time, people capture the factor risk premium in a way to improve return over the long term.
TA: How have factors reacted to different market sentiments like bearish markets or bullish markets?
Luk: Actually, in our research, we try to look at how factors perform differently during different market sentiments because when investors have different sentiments, they try to reward and punish stocks with different factor characteristics. For example, low volatility and dividend stocks tend to perform better when investors feel bearish because they usually feel that low volatility stocks and high dividend stocks are safe havens when they feel panic.
In contrast, value stocks are normally well rewarded by investors when they feel upbeat and bullish and that’s why we noticed that value stocks tend to do better when investors are bullish.
TA: How about in different market cycles, how do factors perform?
Luk: If you look at the market trends, they are classically divided into bullish trends, bearish trends, or recovery trends.
For example, in a bearish trend we notice that low volatility stocks and quality stocks tend to be more defensive because they also tend to have lower volatility. That’s why we noticed that they perform better during neutral and bearish trends than in a bullish trend.
In contrast, momentum stocks perform very well in a bullish market. However, when the market is in a trend reversal, for example, if the market recovers from the trough momentum stocks tend to suffer a lot because momentum tends to capture the benefit from price change. And that’s why whenever the trend changes, they (momentum stocks) suffer a lot and they tend to underperform the market a lot.
TA: In terms of asset allocation, how can you apply factor-based strategies?
Luk: For factor-based strategies, of course people can do single factor investing even though as I mentioned there is cyclicality in the performance. However, if you look at the long-term performance like low volatility or dividend, they have excess return of almost nine percent compared to the broad market without too much excessive risk. Therefore, the inclusion of this factor in a strategic portfolio may improve the overall return.
On the other hand, for some of the investors, especially the more sophisticated, they may even do multi-factor investing or even factor rotation in their portfolio which is becoming more and more popular now.