Murphy: It’s no surprise that multi-factor equity strategies have lagged their market cap benchmark in the past couple of years. These strategies either outperform or underperform depending on the market environment, such as a high beta-driven growth rally. If single factors underperform simultaneously, then the multi-factor diversification may not hold up as you would expect and the portfolio might lag the mar- ket cap benchmark. We saw momentum and quality behave in a similar way throughout 2018. Stocks that were ranked strongly on quality factors also happened to demonstrate strong momentum, such as some of the information technology stocks. When it comes to a smart beta allocation decision, it will likely be a bit more expensive than a traditional index and will be anchored to the market cap index from a performance perspective. Whether it is performing as we would expect, or out/underperforming the global benchmark, we need to understand why. Peach: Which is what the client will focus on. They will have moved potentially from an active portfolio with the MSCI World as a benchmark, so they will be thinking about what they have moved from. A lot of multi-factor products in the past 18 months have struggled. But if you look at the market leaders over that period, they are companies with significant negative cash-flow, which has not been the case since before the dotcom crash 20 years ago. If you are looking to allocate towards factors that use fundamental data to find companies that are profit- able or cash-flow generative, by definition that strategy will not do as well when companies generating negative cash-flows are the ones outperforming. They have underperformed market cap, but they have performed as expected in that environment. If factors always outperformed they would be a free lunch. So this period of underperformance is actu- ally helping to tell the story about factors, that they can underperform over a period is the principal risk related to a market cap benchmark. Whilst some of these multi-factor products have underperformed market cap in the short term, most have outperformed over three to five years. Our research showed that there’s a better than a 50/50 chance that a multi-factor product could outperform over shorter periods. Over three or five years you are looking at a much more significant chance of out- performing the market cap. Scott: When there is an underperformance for good reason it is difficult to tell a trustee that this is a good idea. That must be one of the difficulties in selling it. It is the same with fiduciary management. A lot of the decisions taken have been defensive at a time when markets are going up. When they went down in the fourth quarter some fiduciary managers didn’t pick up on that. Trustees need to understand that this is a long-term game and should not be looked at quarterly. Leeuwen: We have a model and a fund that follows duration decisions as well. We have applied that strat- egy for 20 years taking long and short duration positions in a global government benchmark. We haven’t once overridden the model. Even when everybody was doubting quant models, when they saw negative rates and quantitative easing. It’s not the Holy Grail but it adds value in the long run to a portfolio when you complement it with other strategies. Scott: It is about sticking with it in the long run. Leeuwen: Generally, in back-testing and academic research you will see lines trending up. The biggest risk is that people believe that factor credit is always a win- ning strategy, but that’s not the case. There is no free


12 September 2019 portfolio institutional roundtable: Factor investing


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