Investment management styles - Factor Investing

Investment management styles vary. Most people are aware of passive funds management, where a fund manager follows a particular index. Active funds management is also well known, where fundamental research analysis is used and funds are actively managed to potentially add alpha.

There is also another way of investing which is less known and that is called Factor Investing, which takes a view that certain factors on average are more important in capturing sharemarket returns than others. Advances in technology have assisted enormously in the development of factor investing.

The best known factors to build a factor-tilted portfolio fall into four categories. These are:

• Size -  for example, small caps versus large caps
• Value - this includes dividend yield
• Volatility -  buying less risky stocks which exhibit growth characteristics
• Momentum - buying stocks which have risen over the recent past and removing stocks with a high probability of underperforming.

Momentum as a factor

Of all these factors, a portfolio that tilts to momentum in a risk adjusted manner may capture market performance in a much more refined way than one that ignores momentum. But what is momentum? Momentum is a proposition that stocks which have performed well relative to peers, on average, continue to outperform and stocks which have performed poorly tend to continue to underperform.

If momentum factors in the stock market are followed in a systematic and rule based way, emotion is substantially removed from investment decisions and portfolio returns tend to be higher. Human behaviour is a strange beast. It is a known fact that investors can often hold onto losing stocks longer than they should - in the hope they will turn around and often investors sell their winners way too early. Also investors are likely to take heed of recent results and therefore underreact to recent data or news events and on the flip side once data or events are absorbed, they may overreact in the other direction. The herd mentality is alive and well.

Factor investing sets aside emotive decisions, and taking note of momentum factors in particular has proven to be a driver of markets. It is especially interesting to note that research suggests that momentum is one of the key drivers of the Australian equity market. In fact, momentum as a factor is stronger in the Australian equities market, more than most other developed markets around the world. Possible explanations for this include the high participation rate of retail investors and the size of institutional investors with respect to the size of the local market. Another explanation is that the Australian stock market lacks broad diversification across sectors and stocks. In any case it is important to be cognisant of local market idiosyncrasies when constructing an Australian equities factor portfolio.

Momentum in a portfolio can be represented in a number of ways however; it is clear from examining global markets over long periods of history that there are several risks associated with simplistic momentum signals. For example, momentum returns are likely to be negative around market turning points. Stock prices can be under-priced in the short term and can be over-priced in the long term. All of this highlights the importance of combining a momentum signal with a fundamental pricing signal for risk management purposes.

Platypus Systematic Growth Fund

There are few opportunities for Australian retail investors to invest in a factor based portfolio. Platypus Asset Management however does run a factor tilted portfolio called the Platypus Systematic Growth Fund which has successfully outperformed its benchmark since inception. To mitigate the problems with simplistic momentum risks, Platypus Asset Management uses various techniques in the construction of its momentum signal.

The result was Platypus’ proprietary momentum signal. Consistent with research, a raw momentum signal can be volatile. To reduce this volatility, Platypus complements the momentum signal by overlaying a growth-style fundamental signal. This is based on evidence which suggests that growth stocks are more likely to be higher quality firms and following on from that, companies that are higher quality are less likely to fail.

Overall the Platypus Systematic Growth Fund offers investors a real opportunity to:

• Generate outperformance: The fund has exposure to factors which are proven to add value in the Australian equities market. It invests in high quality companies with good future growth prospects.
• Diversify: Creates a more diversified portfolio often in investment classes underrepresented in an investor’s portfolio. This fund complements a portfolio with other strategies like value strategies and actively managed strategies.
• Get exposure to the upside but risk controlled: The fund is fully exposed to equity market risk (i.e. Beta) and participates fully on the upside while reducing risk in down markets. The risk is well controlled, stable through time, and helps account for volatile market conditions. This helps investors mitigate risk across market cycles.
• Attain transparency: The investment process is highly transparent, disciplined and consistent.
• Access a compelling investment at a low cost: The fund has a low base fee.

The Platypus Systematic Investment Process

The Platypus Systematic Investment Process provides investors with a dynamically managed risk adjusted factor exposure. The fund adds value through a top down portfolio construction process. The fund is well diversified and normally holds around 80 to 100 stocks. The historical tracking error is in the range of 2% to 5%. It will also generally be overweight small capitalisation stocks.

There are four distinct stages of the investment process:

1. Momentum filter
2. Fundamental growth filter
3. Portfolio construction
4. Implementation

Once the first two filters have been applied, a list of the most attractive stocks is created with the process run every month in order to capture the best opportunities.

Important information
Units in the Platypus Systematic Growth Fund are issued by Australian Unity Funds Management Limited ABN 60 071 497 115, AFS Licence No 234454. Information provided here is general information only and current at the time of publication and does not take into account your objectives, financial situation or needs. In deciding whether to acquire, hold or dispose of the product you should obtain a copy of the Product Disclosure Statement which is made available on this website and seek professional financial and taxation advice. This information is intended for recipients in Australia only. Past performance is not a reliable indicator of future performance.