Finding Value in Volatility

The severity of the coronavirus on the broader economy is significant and investment markets have reacted in dramatic fashion with the MSCI World ex Australia Index falling -18.2% (AUD) from 19 February to 17 March. Over the past four weeks we have seen many value-based strategies struggle in what has been a difficult time for investors. We believe the key influences on value over the past four weeks have been:

• Economic risk: Falling interest rates and oil prices have provided strong headwinds for many traditional value strategies, which carry large overweight positions to the financials and energy sectors.
• Heightened risk aversion: As the VIX Index of expected volatility hit record levels, we have seen investors rush to sell smaller cap and more volatile securities that have more recently looked to be a better value.
• Flight to quality: With the increased uncertainty higher quality companies with more conservative balance sheets and better profitability (e.g. those in first quintile as illustrated in Exhibit 1) have outperformed the index.[1]

Going forward, the current market environment presents potentially attractive opportunities for long term value investors. Valuation spreads between the cheapest and most expensive companies are back to levels last seen in 2008, which preceded the strong value performance in 2009.1 In the short-term the key to managing risk will be to minimize exposure to economic risks by maintaining a sector neutral posture and diversifying exposures through multiple factors (such as quality and low volatility) to complement value. Lastly, it is important to consider multiple metrics that span both historical and forward looking perspectives when defining value.

VALUE: SINCE THE MARKET PEAK

Since the market peak on 19 February 2020, global equity markets have been extremely volatile as the VIX Index reached record highs. We have seen factors such as quality, momentum and low volatility perform better relative to the index.[2] However, the value factor has underperformed over this period; Exhibit 1 shows the performance of different factors by quintile, with quintile 1 representing the highest exposure to a factor and quintile 5 representing the lowest exposure. For value, quintile 5 outperformed quintile 1 by 3.8% since the market peak.

When looking at the performance of value, it is important to note that not all value stocks have underperformed. In fact, we see that some of the excess returns illustrated in Exhibit 1 have come from pockets of value. In Exhibit 2, we look at the performance of market segmented by value and other factors. Although value stocks as a whole have underperformed, there is a large dispersion of returns among value stocks.

Looking across the factor landscape in Exhibit 2, we see that the combination of value and low volatility stocks was the best performing segment of the market over the past four weeks (measured by excess return relative to index).1 The spread between the cheapest highest volatility and cheapest lowest volatility stocks was 21%. In fact, combining value with low volatility can lead to superior returns, showing the value of the approach.

Over this most recent period we have seen the benefits of investing at the intersection of multiple factors, which is a hallmark of our investment approach at Northern Trust Asset Management. We believe that through investing at the intersection of multiple factors, investors are better able to harvest factor premia and avoid dilution. For example, approaches that equally weight single factor portfolios or indices will have exposure to unwanted factors, such as low quality, low momentum, low value and high volatility. On the other hand, when we target multiple factors, we aim to invest only in the intersection of compensated factors, avoiding low quality, low momentum, low value, and high volatility securities. This maximizes exposure to targeted factors and increases the efficiency of our strategies.


BUILDING A ROBUST VALUE EXPOSURE

One of the main challenges for unconstrained value strategies is that they can carry significant embedded sector exposures. In Exhibit 3, we look at sector excess returns over the period and compare that to the active exposures of the MSCI World ex Australia Value Weighted Index versus the MSCI World ex Australia Index. Over this period we have had seen significant decreases in interest rates globally. The U.S Federal Reserve cut rates to zero, which has dragged down the performance of companies in the financial sector, specifically banks. Further, as tensions escalate between Russia and Saudi Arabia, oil prices have fallen sharply. This resulted in large falls across the energy sector. The financials and energy sectors represent the two largest overweight positions in the MSCI Value Weighted Index. Further, a large underweight to the health care sector has materially and adversely impacted performance.

Left unmanaged, many value strategies are proxies for economic risks such as interest rates and commodity prices. Through periods of heightened economic uncertainty, we believe it is critical from a risk and return perspective that factor based strategies are constructed on a sector neutral basis. This is especially true for value based strategies that are prone to large structural biases.

Our research shows that factor-based strategies investing at the intersection of compensated risk factors may produce targeted risk-adjusted returns through higher returns, lower risk or both. Further, our quantitative strategies look to minimize exposure to other risks and uncompensated factors. We consider sectors and regions to be uncompensated over the long term, and therefore we look to minimize our variation from the market.

VALUE FOR THE LONG TERM AND THE CURRENT MARKET OPPORTUNITIES

In the past four weeks, we have seen large dislocations in the market and this has had a significant impact on investment portfolios. Factor based strategies that have invested at the intersection of multiple factors and minimized exposure to economic risk have performed relatively better. We believe the current market dislocation is currently presenting greater opportunities for value based strategies going forward, as longer term investors are able to take advantage of the short term selling which is not entirely driven by company fundamentals.

There has been much conversation around the industry regarding the potential to add value by timing factor exposures. We believe that factor timing strategies are extremely difficult to successfully implement. They add a significant degree of risk that we do not believe will be appropriately rewarded over time. However, we think that value strategies with the discipline to buy securities when they are relatively cheap and sell those that are relatively expensive are well positioned to take advantage of the current market environment.

In Exhibit 4, we show the valuation spread (z-score) of the top and bottom quintile of securities based price-to-book ratios. Positive z-scores represent value being relatively inexpensive and negative z-scores represent value being relatively expensive. Historically, large positive valuation spreads have preceded relatively strong returns for value. Although no one has a crystal ball, the value factor is now as cheap as it has been since the global financial crisis.2 Value strategies already presented significant opportunity at the end of 2019 and we believe the future opportunity has only increased with the recent market volatility.

We believe that the current market environment is presenting a great opportunity for long term value investors. However, in the short term, the key to managing risk will be to minimize exposure to economic risks and to diversify the portfolio exposure by considering multiple factors to complement value.



1 Past performance may not be a reliable indicator of future performance.
2 Index is reference to MSCI World ex Australia (AUD) index

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