Factor Alpha & International Investing: Part 4 (of 4)
(This is the fourth in a series of four posts that examine the efficacy of factor-based investing in the International market.)
Active Management Landscape
We firmly believe that active management can provide investors with the opportunity to outperform over the long run. Looking like the benchmark in the international space can provide strategy capacity, but can significantly deteriorate the ability to generate alpha. As well, allocating based on size can lead you to overweighting stocks with poor characteristics that tend to consistently underperform. We believe a sound investment process should be disciplined but also nimble— constantly re-evaluating the opportunity set for the highest-ranking stocks.
In the charts below, we can contrast OSAM’s approach with the index and other Smart Beta approaches. We plot market cap versus value as the dimensions on the chart. Instead of using price-to-book as the value metric of choice we combine 5 factors shown to be more predictive of future excess return: shareholder yield, price-to-earnings, price-to-sales, EBITDA-to-enterprise value and cash flow-to-price.
The dot in the center of each oval represents the average value score and market capitalization for the portfolio while the entire oval accounts for 75% of the portfolio’s weight. The O’Shaughnessy International Equity strategy utilizes both value and momentum as primary stock selection criteria. Even with momentum playing such a prominent role, the strategy exhibits a 19% discount to the MSCI EAFE Value Index and an 11% discount to the Smart Beta approach (PXF). The most prominent difference between OSAM’s approach is the market cap range,1 represented by the width of each oval. All of the indexes share a common trait of the bulk of the portfolio playing in a narrow range among the largest stocks in the universe. We admit this strategy provides asset managers with scale but allowing market capitalization to play such a prominent role in stock selection can significantly deteriorate alpha. Our philosophy, honed over two decades leads us to believe factors should drive the investment decision making process to a far greater extent. We consistently avoid companies that exhibit unfavorable characteristics and hone in on areas of the market that are favorable in the ways we deem relevant.
In addition, the O’Shaughnessy International ADR strategy also utilizes both value and momentum as primary stock selection criteria. For O’Shaughnessy International ADR, the strategy exhibits a 41% discount to the MSCI All-Country World ex-US Index and a 44% discount to PXF.2
We believe active management will continue to work well in international markets. However, investors should be leery of managers charging active fees but look very much like the benchmark. The key to delivering consistent excess returns is to focus on themes that have proven efficacy in picking winners and weeding out losers. Though looking like the benchmark can provide scale, doing so significantly erodes alpha opportunity. Asset managers must deliver alpha and not be afraid to close strategies once costs become too high.
- To put this in perspective, the MSCI EAFE index has an average market capitalization of $55 billion versus $14 billion for the O’Shaughnessy International Equity strategy.
- Average market capitalizations: $55 billion for the MSCI ACWI ex-U.S. versus $38 billion for the O’Shaughnessy International ADR strategy.