Yes, Factors Travel – An International Take on Smart Beta

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By Rob Bush, DWS

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Despite their predominantly American heritage, factors, it turns out, still like to pack their bags and travel. And we’d argue this is a good thing. Just as you might put more credibility in a colleague’s world view if it has actually been honed by international experience, so it lends weight that factors can stamp their passports and work in both domestic, and international, markets. And, of course, why shouldn’t they – after all, ultimately factors are attempting to exploit behavioral anomalies that we should have every reason to believe are at least as prevalent abroad as they are in the U.S.

Here at Deutsche Asset Management, we offer a number of factor based strategies, including those based on international indexes, developed and emerging. Of course a blog like this is not the right forum for a deep dive, but I did want to share just three thoughts on the arguably less discussed topic of international factor investing:

  • What factors worked in the international developed markets last year
  • Why low correlations are also seen internationally, and why that’s a good thing
  • What countries, and sectors, international factors like

2017 – What worked…and what didn’t

Figure One: The excess returns to value, size, momentum, quality and low volatility in the international developed markets in 2017 (12/16-12/17)

Source: FTSE Russell for the period of 12/16 through 12/17. Past performance may not be indicative of future results. See glossary for index definitions. Cannot invest directly in an index.

As Figure One shows, four of the five main factors that one of our multifactor ETFs tilts towards, outperformed the vanilla market cap weighted index last year. There are three main points of interest that we take from this:

  • First, that multifactor approaches have benefitted from holding diversified baskets of excess return sources. Clearly, a single factor low volatility approach would not have worked last year in international markets. Holding all five factors however led to outperformance.
  • Secondly, note that there was a very large divergence in 2017 between excess returns to the size factor across US, international developed, and international emerging markets. In the US in 2017, and in emerging market (EM), large cap stocks had strong years leading to a negative return to size tilts. In international markets however a size tilt helped last year. So it’s not the case that a factor that worked, or not, in the US market has to have a similar performance abroad.
  • Finally, note the puzzle of the Quality factor doing well internationally. Quality is typically thought of as a more defensive factor that does better during downturns. That it had a decent showing in these markets last year points to yet another of the difficulties of factor timing – getting the market cycle call right, and having the factor perform as you’d expect under those conditions. Again, we think that holding multiple factor exposures over the long run and not trying to time them can mitigate this risk.

The excess returns of your international factor premia are relatively uncorrelated? Score!

Let me take a second or two and unpick the title to this section because, lightheartedness aside, it is actually a very important feature of factor investing. First, let’s define some terms. When I talk about “excess returns” for factors I mean the difference between a single factor index, and its vanilla, market-cap underlying index (the same metric in fact from the chart). Over the long run, we argue that, in most cases, the difference ought to be positive, and that comparing a single factor index to a vanilla index is a good way to glean insights into whether that factor has worked.

Second, when we look at a time series of those excess returns, it turns out that both domestically, and internationally, they tend to be relatively uncorrelated. What exactly does that mean? Well, for the five factors that we use, it means that the correlations of the ten pairs of factors (five factors lead to ten unique pairs) are, roughly speaking, not too strongly positive in many cases (strongly positive is bad, strongly negative is good). Why does this matter? Well, it matters for the obvious reason that uncorrelated returns lower risk.

Related: Multi-Factor or Not Multi-Factor? That Is the Question

Let me draw on a simple example to make this clear. Suppose there were just two factors, and that they returned either +2% or -1% every month with 50% probability. Clearly these would be good things to add to your portfolio, as over the long run they would be expected to each add around 1% of excess return (let’s ignore compounding). If you had the choice of having all the +2% returns and all the -1% returns coinciding (correlation of one) then you should probably still consider taking that, given that it would add return. However, it’s easy to see that you’d now either win 4% or lose -2% every month. If, at the opposite extreme, the excess returns were perfectly negatively correlated they would always add 1% to the portfolio (the +2% and the -1% netted off each month). The expected return over the long run would be the same in both cases, but the volatility of the excess turns would be far lower in the negative correlation world (zero in fact in this extreme example).

So the bottom line is that, while even very highly correlated excess factor returns might still be beneficial, the relatively uncorrelated nature of international factor premia is a very nice result for investors because it offers the potential to lower the volatility of excess returns, effectively smoothing the alpha profile of a multifactor fund.

For factors, Japan is the destination of choice

One final comment on international factor exposures is the extent to which the fund's investment strategy - which tilts towards value, size, momentum, quality, and low volatility – goes overweight in Japan and, from a sector perspective, in Industrials. With one of the biggest equity markets in the world, Japan, of course, is already the largest component of the market cap developed country index. In 2017 the average weight to Japan in the FTSE Developed ex US index was 21.5%. For the multifactor tilted version of that index, the weighting was taken up to 25.6%, an active overweight of more than 4%.

Now, it’s important to emphasize that with a bottoms up factor methodology like ours, what happens at the sector and country levels is driven by what happens at the stock level. So when one sees an overweight like this in Japan it ultimately comes from Japanese stocks exhibiting the types of characteristics that we want to tilt towards. What is it about Japan that the factors like? Well the country’s stocks generally score well across the factor board so are fairly consistent performers in all five factors.

At the sector level, the largest overweight is to the Industrials which were taken last year from 13.9% in the market cap index to around 21.2% in the multifactor portfolio, an active overweight of around 7.3%. The international Industrials sector has historically tended to score reasonably well on Quality and Size.

So the bottom line is not to overlook factor based approaches when considering your international allocations. Factors seem to like to travel, and to get a little off the market-cap beaten path when they do by visiting different countries, sectors, and stocks.

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