Furthermore, it is argued that value stocks are much riskier than growth stocks in bad economic times and moderately less risky in good times, resulting in an asymmetric risk profile.
On the other hand, behavioural-based explanations for the value factor include the idea that investors tend to extrapolate past growth rates when evaluating a company, and therefore place undue emphasis on those inflated results, persistently over-pricing growth companies and under-pricing value companies.
When observed over the long term, academic research indicates that both factors deliver a premium to the wider market.
However, over the shorter term, we can also see periods of relative under-performance, as shown by the below chart which illustrates the two-year performance of the value and size factors in comparison to the broad MSCI World index, in terms of the growth of £10,000.
Short-term value, size, and broad equity market returns
The value factor has outperformed the broad global equity market over this period, driven by a strong 2022 in which investors sought the stability of value stocks’ shorter-term cash flows (in contrast to, for example, growth stocks’ longer-dated cash flows), in a period of increasing inflation and interest rates.
On the other hand, the size factor has underperformed the broad global equity market over the same time period, with rising interest rates leading to concerns regarding the strength and stability of smaller sized companies, particularly as the global economy progresses through a more challenging period.
However, when we look over longer timeframes, this short-term noise fades away, and the premium delivered by these factors over the wider equity market becomes clear.
As such, periods of short-term relative underperformance exhibited by factors are of limited concern, and they in part provide a buying opportunity at more favourable prices, for the factor in question.
By utilising a diversified factor-based approach, risk is spread out between the factors, enabling the harvesting of the suite of factor premiums over the long term.
Long-term factor and market returns
In summary, factor investing is an investment approach that involves targeting quantifiable factors that can explain differences in security returns.
Size and value are two of the five most widely accepted factors, with their focus on small-cap companies and relatively cheap securities, respectively. While we see variability in returns over the short term, over the long term these factors have delivered a clear and consistent premium to the broad global equity market.
In the next and final article in the series, we ill go on to explore the fifth factor in the factor investing toolkit – momentum – and how this can add value as part of a diversified factor-based strategy.
We will also cover the topic of sustainability, and how this can be incorporated as part of a wider factor-based approach.
