Factor Alpha & International Investing: Part 1 (of 4)
(This is the first in a series of four posts that examine the efficacy of factor-based investing in the International market.)
Strategies should deliver concentrated factor exposures designed to deliver alpha. Unfortunately, the proliferation of factor investing over the recent past has missed this key point. Instead, most factor-based or Smart Beta strategies consist of hundreds of holdings where the bulk of the weight is allocated to the largest companies while providing only slight factor tilts. A heavy large cap bias prevents strategies from exploiting wider dispersion within the small and mid-cap areas of the market. Smart Beta affords investors muted alpha potential but enables asset managers to achieve large assets under management.
We believe in the opposite. Strategies should offer investors high alpha potential while scale is a secondary consideration. According to Morningstar, U.S. equity investors have allocated approximately $375 billion to passively managed indexes, ETF’s or Smart Beta strategies while actively managed funds have experienced approximately $308 billion of outflows over the past 12 months.1 The active versus passive debate has largely been discussed in the context of U.S. equity markets but smart beta strategies have proliferated in the international space as well. International markets deserve more attention as they present an outsized alpha opportunity relative to the U.S.
As of the end of 2015, foreign equities accounted for approximately 47% of market capitalization according to the MSCI All-Country World Index. However, foreign stocks represent 76% of the 7,500 company opportunity set.
Despite the size and breadth of international markets, according to Morningstar, U.S. mutual fund investors allocated approximately 27% of their equity allocation to international funds as of the end of 2013. “Home Bias” is not unique to the U.S., this phenomenon is observed in other developed countries such as the U.K. and Canada
Reasons for “Home Bias” among investors include familiarity with the stocks in their home country and the belief that their home country will outperform other regions. From May 2010, the U.S. has outperformed foreign markets in 62 of 68 rolling 3-year periods. Since the 1970s there have been four prior cycles of U.S. outperformance, which tend to persist for several years. Just as stocks, bonds and commodities such as oil come in and out of favor, a similar rotation happens among foreign and domestic stocks.
Cyclical Nature of U.S. vs. Foreign Returns:
(Rolling 3-Year Relative Returns, 1970–2015)
Within the institutional money management space many believe that you are better off going passive in the most efficient markets. We will examine international markets and address the dueling motivations of active managers seeking alpha and achieving scale. We will take a look at the structure of international markets and highlight how to take advantage of return dispersion and why factor investing is even more effective than in the U.S.
Factor Alpha Efficacy
Our goal is to generate alpha with a disciplined, repeatable process. We define our opportunity set as the universe of developed international stocks with a market capitalization greater than $200 million. A common way to evaluate the efficacy of a factor is to compare the return spread between the highest- and lowest-ranking decile. We can quantify the alpha opportunity by comparing the return spread of the two most important selection factors – value and momentum to the U.S.
Factor Alpha Spreads:
From 1988 to 2015, the spread between the cheapest and most expensive decile by value2 in international markets is 19.2%, exceeding the 18.2% spread for the U.S. For momentum,3 we also see a greater spread in international markets of 12.8% versus 10.3% for the U.S. The wide spread suggests there are significant benefits derived from aligning portfolio characteristics with the proven themes of valuation and momentum. In particular, within the international space these themes have exhibited outsized efficacy relative to the U.S.
Beyond Market Cap — How Best to Pick Winners vs. Losers?
We would like to understand the alpha opportunity available to investors. To do this, we perform a simple test assuming we know in advance the return of each stock over the next 12 months and rank the return by quintile within each market cap bucket. The universe of small-cap stocks has the greatest return spread between the highest and lowest quintile of 121%. Not surprisingly, as we move up the capitalization range the spread declines to 103% for mid-cap and 93% for large-cap stocks. The wider dispersion in returns for small and mid-cap companies suggests there are greater opportunities for outperformance as you move down the capitalization spectrum.
Return Distribution by Market Capitalization:
To exploit the inefficiencies within international markets it is important to determine if there are common themes between winners and losers across the cap spectrum. To achieve this, we calculate average valuation, quality and growth characteristics of outperformers and underperformers. Across the cap spectrum we see that winners consistently exhibit higher return on invested capital. The strong performers are also more conservative in terms of debt issuance while displaying greater growth metrics. A cornerstone of our process is the belief that expensive stocks have high or unsustainable expectations built into their price. As a result, they tend to mean revert and underperform over the long run. The strong-performing stocks have traded at approximately a 20% discount across all cap ranges over time.
Characteristics of Outperformers and Underperformers:
- See http://www.thinkadvisor.com/2016/06/17/passive-funds-trounce-active-rivals-in-may-morning#
- Value defined as price/sales, price/earnings, EBITDA/enterprise value, Price/Cash Flow, and shareholder yield; weighted equally.
- Momentum defined as 3-, 6-, and 9-month momentum and 12-month historical volatility; weighted equally.