Factor investing – Chinese portraits of investment factors for equities…

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A Chinese portrait is a metaphorical description of something or somebody via a comparison with various things or elements, an animal, a flower, a film, an historical character, a dish, whatever…

We’ve adapted this game to take a light-hearted look at a very serious subject, the investment factors that determine the performance of an equity investment (see below).

The investment factors that really matter for equity markets are low volatility, value, quality and momentum – these are the fundamental drivers of equity returns and are exploited in many factor-driven funds.

Exhibit 1 : The four key investment factors determining equity investment performance

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Low volatility – low risk stocks

If low volatility were a virtue, it would be caution, as an investment that relies on this factor will overweight the least risky equities and avoid the riskiest. Were low volatility to be a material, it would be water, naturally returning to the placid state of a peaceful lake. If low volatility had a fault, it would be its inherent timidity, keeping it from being fully invested.

Value – stocks that are inexpensive (perhaps relative to the assets on the balance sheet)

Now if value investing were to be a virtue, it would be justice – the justice of allocating one’s capital to equities on the basis of the intrinsic value of the underlying companies rather than exuberant market valuations. Value’s shortcoming would be its blindness – value does not try to figure out why a company is not expensive –it sees only the balance sheet. As a colour value would be brown, like the earth into which all foundations are laid.

Quality – e.g. stocks of companies with strong financial metrics

If quality-based investing was a virtue, it would be courage – the courage to believe that efficient companies will be rewarded for their excellent fundamental attributes. As a colour, quality would be green, the colour of plants,symbols of growth. Were quality to be a musical instrument, it would be a trumpet leading the charge. Gullibility is quality’s fault but if quality was a super-hero, it would be the Human Torch. As an element, quality would be fire.

Momentum – stocks that are trending…

Momentum-driven investing would be moderation, were it to be a virtue, the virtue that consists in accepting that no single investor knows everything and that others may also be right, even if it is not always apparent why. As a material momentum would be air, adapting to all recipients. If momentum were a musical instrument, it would be a harp, the ultimate light accompaniment. If momentum has a fault, it’s the frivolity that leads it to change its mind, often for no apparent reason.

Exhibit 2 : The Chinese portraits of the four key investment factors determining equity investment performance

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These crossed ‘Chinese portraits’ of the four main investment factors give you an idea of why they are especially effective in investing: application in unison makes them strong. [divider] [/divider]

This article was written by Etienne Vincent on 20 June 2016 in Paris

Etienne Vincent

Head of Global Quantitative Management, THEAM

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