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'For factor-based investing, overcrowding is oversold'

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Last year, we flagged the potential for better long-term risk-adjusted outcomes through rules-based factor indexes, focusing on how the Local Government Pension Scheme could take advantage of this.

Fast forward to the present and we have seen more sophisticated and widespread use of investment products based on factors, including things such as volatility, size or quality.

As is often the case in financial markets, something offering an attractive risk and return profile will invite more investment. Although greater attention in an investment strategy is generally a sign of success, it should be monitored to ensure that the expected risk and return will persist.

The main danger to be aware of is overcrowding. Like in public spaces, it is the presence of more people or things than is comfortable, safe or permissible.

If you have turned away from a seemingly packed café struggling to believe people are still standing in the queue, but been surprised as six more joined the line, you have seen that people can be inconsistent.

It is not self-evident that your rationale for turning away is wrong but neither is that true of the additional queuers’ choice. They are simply different decisions driven by individual appetites, whether based on hunger, patience or interest in that particular venue.

In a similar vein, those trying to predict factor overcrowding often look to valuations as the metric of choice, typically using price-to-earnings measures – the share price against earnings per share.

Logic dictates that, all else being equal, if the price-to-earnings ratio of a group of stocks is higher now than a year ago, those stocks are more ‘expensive’. If we link in additional demand for a factor exposure, as has been the case in passive factor-based products, it is logical to conclude that the proliferation of these products has led to stretched valuations.

For the risk-averse, this fact may be the only proof needed to justify steering clear of further investment – and might even prompt divestment – but that understates the complexity of the market and overstates our ability to predict bubbles.

Stock valuations are just one method of evaluating the relative ‘richness’ or ‘cheapness’ of a stock or group of stocks. If we can link richness with excess demand through factor-based product proliferation, then we are on our way to a more informed state of factor valuations.

While demand for factor-based strategies has been increasing in recent years, this only tells us half of the story. We also need to consider the supply side of the equation. In other words: are factor-based investing strategies the most popular destination for index-tracking investments, or are they just more popular?

The answer is that index investors still tend to prefer traditional market cap-weighted funds over factor-based strategies. While demand for factors has increased, there is not enough hype for factor-based index funds compared with more traditional passive vehicles.

With this vast disparity in place between market cap and factor-based index fund flows, it is hard to make the case that factors are overcrowded.

Factor returns are cyclical and subject to drawdowns, or falls in value, over time. The factors also do not behave in tandem and can be used to achieve certain objectives on their own, or in combination.

This is to say merely observing performance of a factor strategy over a period is insufficient to proclaim its failure.

Based on valuations, more risk-averse investors may believe that factors are overcrowded, but we believe that there are a few more spare tables at this café.

Disclaimer: The value of any investment and any income taken from it is not guaranteed and can go down as well as up, and investors may get back less than the amount originally invested. Legal & General Investment Management Ltd, One Coleman Street, London, EC2R 5AA Authorised and regulated by the Financial Conduct Authority.

Column sponsored and supplied by LGIM 

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