Better Diversification using Style Factors

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In our first note on equity investing, Optimus explained that investing in equities over the long-term should produce good real returns. However, there are risks associated with investing in equities and many academics have sought to understand and exploit different risks, in pursuit of improved share price performance.

Performance of a portfolio relative to a benchmark such as an index is of interest to investors, but may not protect the capital invested. It is seen as a measure of skill on the part of the manager, which can carry significant economic rewards. It is no surprise to learn that substantial quantities of academic literature are devoted to seeking (or indeed debunking) the Philosopher’s Stone of investing, namely a permanent edge on other investors, to achieve persistent above average returns.

In attempting to explain why share prices move, a number of academics, building on work by Fama and French, have sought to break down the sources of return in share price movements by examining various ‘factors’ which might cause shares to move in either a correlated, or uncorrelated fashion with other shares. This would help determine if a portfolio with particular characteristics could be relied upon to outperform the market over time.


The Fama/French model sought to examine characteristics such as size, (i.e. shares in smaller companies did better over time than the broader market). The second of three factors in their model was designed to discover whether valuation of shares had any impact on subsequent share price performance, (i.e. whether companies which were ‘cheap’ or ‘expensive’ continued that way or did the cheap become more expensive and the expensive cheaper over time?). Their conclusions were that, empirically, one could observe a statistically significant positive return from both smaller companies’ shares and ‘value’ investments over time.

This is illustrated by the chart above looking at UK equity returns, and the same phenomenon is observable across the world. Comparing left and right halves of the chart, it can be seen that smaller companies outperform larger companies in each category – value, growth and the broader market in between. The chart also illustrates that value outperforms growth, whether for large or small companies.

There are a number of reasons for these phenomena; for smaller companies, new and emerging technologies will exhibit themselves first in small companies, rather than larger ones; smaller companies may have higher sensitivity to a new contract or product and have greater flexibility to respond to competitive entrances or to launch new products; smaller companies may, however, be high risk, since they are possibly less well-known, in brand terms, may have less supportive, or well established, relationships with providers of finance and may be more volatile in business performance. For whatever reason, it has been observed that smaller companies’ shares tend to outperform larger companies’ shares over the long-term and on average. This premium is seen as a reward for both the volatility alluded to above, but may also reflect lower liquidity in financial markets and therefore a higher risk to investors, which must be compensated.

The rationale for ‘cheap’ or ‘value’ shares performing well over time seems to rest in behavioural finance, in that investors tend to pay greater attention to, and higher prices for earnings generated by faster growing companies than to steadier performers. Some would suggest that this persistent return to value should be arbitraged away over time, (i.e. if this phenomenon is observed consistently investors should exploit it by going long the best value shares in the market, and short the worst value-instruments which are readily available). Empirically, this does not appear to happen and, over a long period, and on average, value shares have outperformed growth shares.

As an aside, there are various criteria which are used to group shares into a value or a growth category; price to book value of assets, (i.e. companies with valuable assets, but low share prices); companies which pay a high dividend income; companies which have a low price to earnings ratio. These measures tend to become pronounced when companies are in financial difficulty and, in a capitalistic economy, the risks of insolvency may loom. In reality, low valued assets may have a higher value to another owner, either in order to consolidate an industry, or to allow a foreign entrant. For example, acquisitions may take place where companies’ share prices fail to reflect the value of its tangible or intangible (brands etc.) assets. This may lead to an acquisition premium being paid and returns to value investors enhanced.

These two factors, size and value, offer investors a better and different way to diversify equity portfolios than just adding more shares to a portfolio to reduce the individual riskiness of one share.

We extend the principle of seeking sources of risk and return which similarly do not correlate with existing bond or equity markets, (e.g. Real Estate, Infrastructure, Emerging Market assets, Hedge Fund replication strategies), and are examining the potential for exploiting the risk premiums in commodities and currencies. In this way, we believe we can offer enhanced risk-adjusted returns to all our investors.
This paper is prepared by Optimus Capital LLP and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. This document contains general information only and is not intended to represent general or specific investment or professional advice. The information does not take into account any individual’s financial circumstances or goals. An assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial or other professional adviser before making an investment decision. Investment involves risks to both capital values and to levels of income received. Past performance is no guide to future results, and you may not receive back all the money invested.