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Eliminating that Factor Home Bias

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Investors are seeking to capture the historical benefits of factors within their U.S. allocations so why not internationally?

Investors have flocked to single factor ETFs with $90 BN in flows over the past 10 years. However, when dissecting these flows further, one can’t help but notice that U.S. factor ETFs have captured the majority of flows and investor adoption of international factor ETFs has lagged.[1] While investors have embraced both U.S. single factors and broad international markets, they have been slower to adopt international single factor ETFs despite international single factors offering the potential for return enhancement or risk reduction. Are investors missing an opportunity to pursue the potential benefits of factors in their international allocations? We would argue yes.

The role and use of factors in a portfolio shouldn’t stop with U.S. equity. Factors have been the long-term drivers of investment returns; their benefits and behaviors have persisted not only in U.S. markets but also in non-US markets. As a result, much like factors are used in a U.S. equity allocation, factors can also be deployed in international markets to seek enhanced returns or reduced risk. Not unexpectedly, international single factors have retained similar return and risk characteristics to their U.S. counterparts allowing investors familiar with U.S. factors to easily extend their use of factors to international markets. To illustrate, we evaluate the historical behavior of three single factors – quality, momentum and minimum volatility.

Using Factors to Beat the Market

Certain style factors such as quality and momentum can be deployed with the goal of enhancing return relative to the broader market. In the graph below, we examine the performance of these potential return-enhancing single factors in both U.S. and international markets. As expected, U.S. quality and momentum has outperformed the broader U.S. market over time.  However, does this return-enhancing behavior of the quality and momentum factors hold in international markets? Indeed, the outperformance of quality and momentum factors has persisted in international markets over time. In fact, from January 2015 through June 2019, the international quality and momentum factors have outperformed the broader market[2] by an average 1.6% and 1.1% per year, respectively. As a result, investors may consider deploying factors within their international allocations in seeking above-market returns.

Using Factors to Reduce Risk

However, what if the investor’s primary objective is not to enhance return, but rather to reduce risk in their portfolio while still remaining invested in the market? A minimum volatility strategy may be appropriate. Within the U.S., minimum volatility has historically delivered lower risk than the broader market as observed in the graph below. Notably, we also observe that this demonstrated behavior of lower risk compared to the broader market also persists in international markets. In fact, from February 2012 through June 2019, international minimum volatility has outperformed the broader market[3] by an annualized 2.1%[4] with only 75.6% of the risk. Thus, investors seeking to access international markets with lower risk or desiring to reduce the risk of their existing international allocations may want to consider using a minimum volatility strategy within their portfolios.

Interested in emerging market factors? Check out Holly’s blog on EEMV here.

Deploying International Factors

In addition to simply using international factors to strategically enhance return or reduce risk overtime, factors can also be deployed more tactically. Similar to U.S. single factors, the performance of international single factors has demonstrated cyclicality. Investors can leverage this demonstrated behavior by tilting toward or away from factors based on the economic cycle. For example, if the economy is headed into a period of slowdown or contraction, investors may want to build resilience into their portfolios and tilt toward quality or minimum volatility, which have tended to perform well in challenging market environments. On the other hand, if the economy is in a period of expansion, tilting toward momentum may be more appropriate.

Conclusion

Factors: quality, momentum, low size, value and minimum volatility, are the historical long-term drivers of returns and their characteristics have persisted within and across equity markets. As a result, investors can use factors across the globe both strategically, and tactically, to seek enhanced returns or reduced risk. The narrative and rationale for both U.S. and international exposures is also consistent, allowing investors’ familiarity with domestic factor investing to extend globally. For these reasons, we believe the prudent investor should consider incorporating the potential benefits of factor investing beyond the U.S, and into their international allocations.

[1] Source: Blackrock, industry flows for value, momentum, low size, quality and minimum volatility Factor ETFs domiciled in the U.S., data from 2009 to 2019.

[2] International quality is represented by the MSCI World ex USA SN Quality Index. Momentum is represented by the MSCI World ex USA Momentum Index. The broader international market is represented by the MSCI World ex USA Index.

[3]International minimum volatility is represented by the MSCI World ex USA Minimum Volatility (USD) Index. The broader international market is represented by the MSCI World ex USA Index. U.S. minimum volatility is represented by the MSCI USA Minimum Volatility (USD) Index. The broader U.S. market is represented by the S&P 500 Index.

[4]Source: BlackRock, Morningstar, data from February 2012 – June 2019. Past performance does not guarantee future results.

Originally Posted on August 13, 2019 – Eliminating that Factor Home Bias

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