Making factors work in Aussie equities
While factor investing has been taken up globally, it’s seen slower pickup in the highly concentrated Australian equity market. That’s starting to change.
The success of traditional active management is mostly due to its exposure to the most common factors: value, momentum, quality, and low volatility. But while factor-based investing has become globally ubiquitous, challenges can arise when you try and port these factors mostly unchanged to the Australian equity market.
“Factor investing has been taken up pretty well in global equities, but there are challenges around the micro-structure of the Australian equity market that’s made investors hesitant in deploying these strategies,” said Scott Bennett, head of quantitative research at Northern Trust Asset Management. “The challenge in the past has been a naïve extrapolation of both factor design and portfolio construction from US and global equity markets to Australia, not bringing the desired performance for those factors.”
“But once we actually take into account those nuances, investors are able to gain the same amount of premia for those factors in Australian equities as you would expect for US and global equities.”
The challenges that factor-based investing has faced in Australia are threefold: the Australian equity market itself, which is one of the most concentrated in the developed world at both the stock and sector level; sector dominance, with financials and materials comprising around 50 per cent of the market compared to 20 per cent globally; and small cap variability and cyclicality, with the bottom 200 stocks of the S&P/ASX 300 making up less than 10 per of the overall market capitalisation, with sector allocations vastly different to the broader market.
“When we come to a market like Australian equities, it’s structured a little bit differently to what we see for a broad global equity market or the US Market,” Bennett said.
“We have very large allocations to financials and materials, and that presents a very significant challenge because the key return drivers for those particular sectors are different and need to be considered. When we look at global equity markets, financials and materials make up a much smaller proportion of the overall equity market.”
There’s also the issue that not all factors – or rather, the companies they’re applied to – are equal. You can’t use the same criteria to judge the quality of a REIT, a commercial bank, or an IT firm. Add on accounting differences between companies, and things get even trickier.
Northern Trust Asset Management aims to solve those problems by developing and applying proprietary factor definitions “at the intersection of the desired factors” to provide the greatest opportunity for outperformance. In the Australian equity market it balances its factor exposure to take into account expected returns, risk, and correlations to develop a “multi-factor” composite of quality, momentum, value and low volatility.
“We make sure that for all our portfolios, not only are we sector relative – we’re looking for those companies that are best in class in the sector – but we’re also sector specific. For example, when we’re looking at how we value a central bank, it’s very different to the valuation metrics we would use for a resource company,” Bennett said.
“That becomes really important for making sure that we’re not getting an apples and oranges comparison across companies and we’re actually identifying the true value of a particular company by using those sector specific metrics.”
Northern Trust Asset Management’s research on factors in Australia research kicked off about three years ago, in response to its success in global equities. NTAM has been running Australian equities strategies for two and a half years, and believes the strategy could make a difference for institutional investors as Your Future Your Super crimps risk taking.
“You’re able to access these proven active return drivers at a much lower cost than traditional active management, and generally with much lower levels of active risk,” Bennett said. “… You’re getting higher risk adjusted returns at a much lower cost level, and that’s really seen a large pickup in interest for MySuper clients where cost is a big driver.”