What do factor investing and UK equity managers have to do with sport?

In our sport of multi-asset, the factor framework allows us to understand the performance of players, and to blend them in a way that is consistent with our market outlook at each point in time, seeking to capture opportunities through market cycles.

What a summer of sport it’s been. First, we had the drama of Euro 2024, followed by the impressive Paris Olympics. Among the variety of discipline and competition, we witnessed a constant: the enduring pursuit of performance by athletes and teams. The level of macro and micro analysis that is carried out in a bid to improve performance will amaze you.

For instance, an Olympic road cyclist will focus on details such as optimal bike settings, diet and the right cadence, to name just a few. He or she will also focus on the expected rainfall, temperature and wind on race day, as these weather factors will have a significant impact on cycling output.

We apply the same philosophy when we look at the way our funds perform. For our active equity managers, we look at both the impact of the macro (the economic cycle and the performance of factors) and the micro (unique qualities of the manager and the process). We do this to gain a better understanding of the quality of the realised performance and whether that can help us to say something about expected future performance.

Starting with the macro

Over the last 10 years to 30 June, UK equities have lagged their European, US and Japanese counterparts. The FTSE All Share Index delivered an annual return of 5.9%, versus 7.7% for Europe, 12.9% for the US and 10.9% for Japan (all in local currency terms).

In terms of active manager performance, the average UK equity manager (the IA UK All Companies sector) underperformed the FTSE All Share index by 0.7% annually over that time period. A similar relative performance of active managers in Japan was observed. In Europe, active managers broadly matched the return of the index, while the relative underperformance was seen to be the largest in the US, where active managers underperformed the S&P 500 index by 2.4% p.a[1].

Digging deeper – and adding a factor lens – tells us a bit more about the drivers of performance in those markets. Looking at annual relative performance of factors versus their respective market cap benchmarks and ranking them on a year-on-year basis, we can observe the following:

1. Over the long term, the performance of UK small caps relative to the market is positive, but in the last three years, size as a factor has generally found it hard to deliver strong relative performance. When we overlay this with what we have observed in a broader economic context, we can understand why. Small caps tend to be more economically sensitive and might therefore tend to underperform in late-cycle environments. Additionally, small cap companies have also tended to have more leverage and have therefore typically found it more challenging in higher interest rate environments, as we’ve seen in the last three years.
2. Value as a factor has seen better performance in the most recent five years, as compared with the prior five years. After a decade of dominance by growth stocks, in more recent time periods, we’ve seen value stocks and the value factor fare better. Again, overlaying what we observe in the broad economic environment, in a higher-rate environment, future earnings are discounted over current earnings, which can appear more attractive, as well as the outperformance of energy, commodity or financial-related stocks. This tends to favour the value factor, on top of the potentially attractive valuation case for value after a decade of weaker performance.
3. Understanding the factor exposures of the manager, and understanding which factors are rewarded in what part of the cycle can help to better predict expected performance of managers. Moreover, a multi-factor portfolio by design will broadly sit in the middle of the band and can therefore potentially offer investors better balance in their investment journey. We believe this highlights the importance of looking across all factors in balanced way, as opposed to only using one or two factors on a tactical basis in portfolios.

Taking these learnings from the macro should also help us when we look at the micro. It is hard otherwise to make a fair assessment of performance.

In part two, we’ll take a look at micro factors in assessing UK equity manager performance.

The value of investments and the income from them can go down as well as up and you may not get back the amount invested. Past performance is not a guide to future performance.

[1] Source of figures: Bloomberg