The five-factor cocktail that spared investors a Brexit hangover

Stan Verhoeven

At NN Investment Partners (NN IP) we strongly believe in the benefits of factor investing, a strategy based on a strong economic rationale and academic evidence with positive long-term expected results. Combining the right factors offers great investment potential and diversification benefits to traditional investments. The NN (L) Multi-Asset Factor Opportunities (MAFO) fund, that has celebrated its 1-year anniversary last month, showed a good performance amid the turbulence around the Brexit vote.

Since its inception on 23 March 2016, the MAFO-fund has delivered investors positive returns, in the face of quite a lot of market uncertainty. On 23 March 2017 the fund was at the top of its Morningstar peer group with a total net return of 18.8% (past performance is no indication of future performance). This reinforces our believe in the benefits of the added value of applying factor investing to multiple asset classes. Investors have to take into account that the fund has a volatility target of 10% and as such there can be drawdowns.

“NN Investment Partners has successfully applied the principles of factor investing for many years now”, says Stan Verhoeven , Lead Portfolio Manager of NN (L) Multi-Asset Factor Opportunities. “The strategy of this fund builds further on that experience and combines the benefits of a multi-asset and multi-factor approach. The fund showed a good performance before and after the Brexit vote in June and July 2016, underscoring the diversification advantages of this approach.”

But how does factor investing work? The approach is not complex in itself. A factor can be anything that structurally drives returns. There are many factors, such as equity risk premium and credit spread, but we focus on the factors that capture non-traditional sources of return such as carry, value and momentum. For example, momentum is driven largely by investor herding behaviour, a well-documented behavioural bias that causes markets to trend. One can benefit by buying assets that have gone up and selling assets that have gone down, thereby “riding” the trend.

The art of factor investing: it’s the combination!

The strategy of factor investing may be straightforward; the art lies in finding the right factors that are able to deliver positive returns after implementation costs and in choosing the right combination. A smart combination of factors not only provides return but also lays the foundation for an effective diversification strategy. Factors tend to have a low correlation with each other and with traditional asset classes. Our MAFO-fund invests in five factors across four asset classes: equity, fixed income, currencies and commodities.

The five factors the MAFO-fund invests in:

Momentum: Performance tends to persist, so we buy the winners and sell the losers
Value: We buy undervalued assets and sell overvalued assets
Carry: High yield investments tend to outperform low yield investments, so we buy instruments with a high yield and sell those with a low yield
Flow: Markets are subject to predictable and excessive buying and selling pressures in the short term. We go long at times of excessive supply and short at times of excessive demand
Volatility: Implied volatilities are generally higher than realised volatilities because implied volatility is a compensation, not an expectation, of volatility. We pay realised volatility and receive implied volatility

How did the five factors and the fund do before and after Brexit?

A good way to illustrate the resilience of the multi-factor approach is to take a look at the performance at the time of the Brexit referendum (Graph 1). The vote had a clear impact on some individual factors, but the MAFO-fund (orange line), based on the combination of factors and assets, generated a positive performance both pre- and post-Brexit, which clearly shows the diversification benefits.

Graph 1: The performance of the five factors and of the MAFO-fund itself pre- and post-Brexit vote. Source: NN Investment Partners

Momentum before and after Brexit profited from the continuation of the long term trend in markets. For instance British government bonds strengthened further Value performed badly in the days following Brexit, when undervalued investments took a hit as valuations worsened. The pound, for example, weakened further
Carry had a small negative contribution the day after Brexit, but soon recovered as the term structure in commodities steepened and yield differentials in currencies normalized
Flow, which benefits from short-term mismatches in valuation resulting from overreaction, did well. The fund was short on the equity markets going into Brexit and long in the subsequent recovery
Volatility did badly, as one would expect in an environment where volatility increases and where the factor is short on implied volatility. However this factor more than recovered in subsequent weeks

When assessing the fund’s performance from an asset class perspective (that is, combining all factors within an asset class), one can clearly see the added value of applying factor investing to multiple asset classes: equities as a whole contributed negatively to the fund the day after Brexit, whereas commodities and currencies were particularly strong. Over a slightly longer time period the equity factors recovered from the drawdown directly after Brexit, thereby further supporting the funds returns pre- and post-Brexit. As such, the Brexit case clearly shows the benefit of applying multiple factors, across several asset classes. This approach creates a clear building block for improving the robustness of portfolios.

NN (L) Multi-Asset Factor Opportunities is a sub fund of NN (L) (SICAV), established in Luxembourg and is duly authorized by the Commission de Surveillance du Secteur Financier (CSSF) in Luxembourg. Several share classes of the sub-fund are currently registered in Luxembourg, Austria, Belgium, Germany, the UK, Italy, Finland, Sweden and Denmark. Please see the prospectus for fund-specific costs and risks.

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