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Equity Perspectives

Here’s how Lord Abbett seeks to identify new risks and also quantify the size of known risks in portfolios.

An equity portfolio manager typically builds a portfolio stock by stock, company by company. Each stock may have a story associated with its presence in the portfolio. Nevertheless, the portfolio also takes on a life of its own, reacting in its own ways to events in the market or the economy. How, then, can one predict what will happen to a portfolio if, perhaps, there is a sharp move in the U.S. dollar? What about a rotation from “value” to “growth” stocks?

An equity-factor model can answer questions like these by using historical data and assuming that future relationships between stocks look like historical relationships. What is a factor? Simply, it is something that stocks might have in common. (See Table 1.) Here are some examples that are common among equity-factor models:

  • Market-cap size (e.g., small-cap stocks)
  • A growth and/or value score
  • Industry or sub-industry of the company (e.g., oil exploration and production)

 

Table 1.  Axioma’s U.S. Equity Risk Medium-Term Model Factors

Source: Axioma AXUS4 Style Factor Handbook.

 

Historically, for example, growth companies have behaved in a more similar manner to each other than they do to value companies. A portfolio of growth companies has outperformed value companies over the past five- or 10-year periods. (See Table 2.)

 

Table 2.  Growth Stocks Have Beaten Value Stocks Over the Past Decade


Source: Russell data, using Russell Growth/Value definitions.

 

Historically speaking, growth and value investments tend to react differently during the economic cycle. Since value stocks are often cyclical in nature, they may benefit from the increased spending that usually occurs during an economic expansion. Growth stocks also may perform well during an expansion, yet they may also fall out of favor during market downturns, when investors pay more attention to price ratios.

While growth stocks are subject to the daily ups and downs of the stock market, their long-term potential as well as their volatility can be substantial. Value investing involves the risk that the market may not recognize that securities are undervalued, and they may not appreciate as anticipated.

[Past performance is not a reliable indicator or guarantee of future results. Performance during other periods may have been different. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.]

Factors fall into different categories as follows:

  • Objective: An unambiguous, factual statistic (e.g., market-cap size)
  • Predefined categories (e.g., sub industry of a company): Note that there are different versions from different data providers, or one could create a unique one. (See Table 3.)
  • Calculated: Even for something with the same name, the formula and time period used may be subjective. For instance, for medium-term momentum, you can use different time periods (e.g., 12 months) and sometimes exclude recent data (e.g., the most recent month).

 

Table 3.  How Russell Measures Growth Stocks

Source: FTSE Russell.

 

Therefore, even for factor models with similar constructs, the results of the models will be different. Despite that, the results of the models will be similar the vast majority of the time, and reveal potentially critical information about a portfolio that may not be otherwise obvious on casual inspection. For risk-management purposes, it is important to make sure that the factors one might be concerned about are included in the model.

Identifying New Risks and Assessing Known Risks
At Lord Abbett, we use equity-factor models both to identify new risks and also to quantify the size of known risks in portfolios. We build stress tests for each factor, and identify scenarios that could significantly affect the performance of different strategies. We typically look at sharp shifts for a factor with relatively low probabilities over a quarter—roughly 5%—to assess where potential risks may lie.  For example, if small-cap stocks outperform large-cap stocks over a quarter, what happens to projected performance? This technique can allow identification and mitigation of many different kinds of risks in a portfolio.

Facilitating Concentrated Stock Strategies
A side benefit of using a factor model for risk is that it facilitates portfolio management of concentrated stock strategies. Diversification of risks is fairly straightforward, with 100 different stocks. With 25 stocks, a factor model is a critical tool for portfolio managers to ensure that risks, intended or unintended, are of a manageable size. Without using a factor model for equity-risk management of a concentrated portfolio, it is almost certain that, eventually, a large exposure to a particular factor will crop up in a portfolio, and potentially wreck performance if markets move the wrong way.

While there are many tools in the risk-management tool belt, using a factor model for monitoring equity portfolio risk is a key tool for best practices today. A factor model also can identify and quantify various risks, help with stress testing, and benefit concentrated portfolios.

 

According to the Oxford Handbook of Quantitative Asset Management, the use of equity factor models is increasingly significantly within the institutional asset management community. They are routinely used to estimate the potential benchmark relative returns of equity securities and portfolios. Equity factor models offer numerous advantages over simple historical observation in providing understandable linkages between security characteristics and subsequent returns, and filtering out much of the random noise affecting returns. Most importantly such models help clarify the distinction between return generating processes that impact a particular security, and processes which are in common across many firms.

The Russell 1000 Index® measures the performance of the 1,000 largest companies in the Russell 3000 Index, which represents approximately 92% of the total market capitalization of the Russell 3000 Index.

The information provided here is for general informational purposes only. It does not constitute a recommendation nor investment advice, and should not be used as the basis for any investment decision. This is not a representation of any securities Lord Abbett purchased or would have purchased or that an investment in any securities of such issuers would be profitable. This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual re turns or results will not be materially different from those described here.

The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. While growth stocks are subject to the daily ups and downs of the stock market, their long-term potential as well as their volatility can be substantial. Value investing involves the risk that the market may not recognize that securities are undervalued, and they may not appreciate as anticipated. Small and mid cap company stocks tend to be more volatile and may be less liquid than large cap company stocks. Mid cap companies typically experience a higher risk of failure than large cap companies.  Small cap companies may also have more limited product lines, markets, or financial resources and typically experience a higher risk of failure than large cap companies. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. The securities markets of emerging countries tend to be less liquid, especially subject to greater price volatility, have a smaller market capitalization, have less government regulation and may not be subject to as extensive and frequent accounting, financial and other reporting requirements as securities issued in more developed countries.  Investing involves risk, including possible loss of principal. Diversification does not guarantee a profit or protect against loss in declining markets. Forecasts and projections are base d on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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