- Value – securities with lower prices relative to their fundamental value
- Size – securities with lower market capitalisation
- Momentum – securities that have outperformed in recent time periods
- Minimum Volatility – securities that demonstrate lower volatility
- Quality – securities that demonstrate higher profitability and resilience
When observed over the long term, academic research indicates that each of these factors delivers a premium to the wider market.
This article series will explore each of these five factors in turn. Rather than beginning with the "classic" factors such as value and size, in this first article we are going to focus our attention on two of the factors of interest in the current economic environment: quality and minimum volatility.
In response to sustained inflation, we have seen the Bank of England and other central banks enact extremely rapid interest rate tightening cycles.
With the consumer price index in the UK falling to 4.6 per cent in October from 6.7 per cent In September, the BoE’s regime of higher borrowing costs appears to be succeeding, at least in the short term, in bringing down inflation.
However, this sharp change from the historically low interest rates experienced just a few years ago is beginning to have a real impact on growth.
October saw retail sales volumes in the UK fall to their lowest level since February 2021, an almost 3 per cent reduction compared with the prior year.
Alongside this we saw UK gross domestic product come in flat over the third quarter, compared with a 0.2 per cent expansion in the second quarter.
Despite the BoE’s forecasts of flat growth over 2024, an increasing number of analysts are predicting that the UK will tip into recession over the coming months, compounded by the expectation that UK monetary policy will remain tight for some time.
Turning our attention back to factors, we can observe that different factors provide relative outperformance compared with the market at different points in time, and at different points in the economic cycle.
While it is extremely difficult, if not impossible, to consistently identify economic cycles and resulting factor performance in advance (with timing being one of the most challenging aspects), historically quality and minimum volatility have typically provided stronger returns in recessionary-type environments. We will now explore these two factors in turn.
Quality
The quality factor focuses on profitable companies, with high returns on equity and consistent profitability over time.
Through this focus on resilience and profitability the quality factor can provide a defensive role in a portfolio, a characteristic in favour during recessionary environments, with firms demonstrating high returns on equity and consistent profitability over time being inherently more resilient in an economic slowdown.
The quality factor also emphasises companies with lower leverage, which again leads to increased resilience to a downturn in economic conditions.
There are a number of potential explanations behind why the quality factor can add value compared with the broad market. These include risk-based explanations, which are founded on excess risk-adjusted returns being achievable due to investors undertaking financial risks, and behavioural-based explanations, which are founded on investor psychology and expectations.
