BNP AM

The official blog of BNP Paribas Asset Management

Multi-factor equity strategies that outperform when rates rise: what’s inside?

A well-diversified strategy invested in value, quality, low risk and momentum stocks should do well, irrespective of which way interest rates move. According to our research, rising rates should not affect this strategy’s ability to outperform a market capitalisation benchmark index.  

Multi-factor equity strategies are active strategies that can better the performance of their market cap benchmarks with a tilt towards value, quality, low risk and momentum stocks.

These days, it is increasingly common for such strategies to include a further layer of preferences for stocks with lower carbon intensity and with the highest environmental, social and governance (ESG) performance. We believe this is a natural overlay because the stocks of companies that operate in a sustainable way tend to have lower risk and higher quality characteristics than their sector peers.

For that reason, multi-factor equity strategies are already typically tilted towards sustainable stocks even before imposing a stricter overlay of sustainable preferences.

In addition, the value and momentum biases of these strategies can help ensure that portfolios tactically avoid investing in any sustainable stock that may have become expensive and started to underperform. Instead, they prefer stocks that are cheaper and/or have stronger momentum.

For these reasons, and because multi-factor portfolios tend to be well diversified, the sustainable overlay has minimal impact on the strategies’ performance over the medium to long-term.

Do rising interest rates affect multi-factor equity strategies?

It is not easy to generalise the impact of interest-rate movements on the ability of an active multi-factor equity portfolio to outperform its benchmark. The sensitivity depends on how it is constructed.

When it comes to our proprietary sustainable multi-factor equity strategies, we take the steps necessary to ensure that the strategy’s excess returns are not adversely affected by interest-rate changes. However, not all such strategies are constructed in this way.

The first and most likely source of exposure to interest-rate changes comes from sector allocations. A sufficiently large active allocation to interest rate-sensitive sectors such as utilities, listed real estate and financials should result in a portfolio with excess returns that are likely to behave differently depending on what happens to interest rates.

To make sure that any interest rate-sensitive sector positions do not contribute significantly to tracking error, we construct multi-factor portfolios with no significant sector contributions to tracking error risk, at least at the macro-sector level.

Even so, this may not be enough. As show below in exhibit 1, even in sector-neutral portfolios, value stocks tend to outperform more often when rates rise than when they fall. On the other hand, sector-neutral portfolios of low-risk stocks are still more likely to outperform when interest rates fall.

These sensitivities could be successfully removed by carefully changing the weight of the stocks based on the exposure of individual stocks in each sector to interest rates, as some are more exposed than others are (e.g., stocks of companies with higher levels of debt).

However, in multi-factor portfolios, we believe it is sufficient to ensure that the allocation to value and low risk is comparable so that their contrasting sensitivity to interest rates cancels itself out. This is relatively easy to do: We simply ensure that value and low risk contribute similarly to portfolio risk.

Empirical evidence

Exhibit 1 shows the risk-adjusted returns (information ratio) of long-short value, quality, low volatility and momentum portfolios, and an aggregation of the four based on an equal risk contribution allocation, with beta and sector neutrality (based on five macro-sector definitions).

Exhibit 1: Information ratio (coloured numbers) and t-stat (numbers in brackets) of macro-sector neutral long-short portfolios, monthly rebalanced with 2.5% volatility based on USD monthly returns

Note: The investment universe is similar to that of the MSCI World index. The long-short portfolios have a beta equal to zero. Calculations from 31 January 1999 through 31 January 2022. Average returns in months when 5-year US bond yields rose by more than 20bp, fell by more than 20bp, or did not move by more than 20bp in either direction. Results with a * in the t-statistic are statistically significant. For illustration purposes only. Source: BNP Paribas Asset Management, MSCI, WorldScope, FactSet.

The underlying excess returns can be obtained by multiplying the information ratios by 2.5%, the volatility of all the long-short portfolio strategies used to construct the table. The results in exhibit 1 give an indication of the outperformance that could have been generated against the MSCI World index in the absence of portfolio constraints and before transaction costs and management fees.  

As shown, sector-neutral portfolios with value stocks have a tendency to perform better in months with rising bond yields, whereas sector-neutral portfolios of low volatility stocks actually fail to outperform in such periods.

The final well-balanced composite long-short portfolio made up of an aggregation of these four style portfolios can do well, irrespective of the direction of interest rates.

In summary

Multi-factor portfolios can be rendered insensitive to interest-rate movements. This requires careful portfolio construction with a focus on removing sector exposures to interest rate-sensitive sectors and a good balance between value and low risk stocks, which tend to have opposite sensitivities to rate movements.

A sustainable overlay to ensure a bias in the multi-factor portfolio in favour of top ESG rated companies and those with lower carbon intensities should have no meaningful impact on these conclusions.

Disclaimer 

Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience.

Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. The views expressed in this podcast do not in any way constitute investment advice.

The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.

Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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