Factors occur in almost all markets and across asset classes, but when implementing a strategy investors do need to be aware of the peculiarities of the relevant markets. We speak to Northern Trust Asset Management’s Guido Baltussen about the application of factors to emerging markets and the impact of inflation
Factor investing has been around for a while, at least since the 1970s when finance professor Stephen A. Ross started to explore different ways to expand the capital asset pricing model (CAPM) beyond just the market factor and developed his arbitrage pricing theory, which is still the foundation of many commercial risk models today.
But for most of its history, factor investing focused on stock prices in the United States. It has only been more recently that this approach to investing was expanded to include other markets and asset classes.
Today, it incorporates a broad range of markets, including emerging markets (EM). But how easily do these factors translate to markets with such different characteristics?
Surprisingly well, Guido Baltussen, Head of Quantitative Strategies – International, at Northern Trust Asset Management says in an interview with [i3] Insights.
At least in the long term.
Over the long run you would expect the emerging market factor premiums to be there, just like developed market factor premiums
“Developed markets last year, especially the US, were a nice example of where [factor investing] was a bit more difficult, driven by the concentration of the magnificent seven. At the same time factors performed very well in other market segments, like small caps, internationally and in emerging markets.
“So in that sense they do behave differently at times, but over the long run you would expect the emerging market factor premiums to be there, just like developed market factor premiums.” Baltussen says.
But there are idiosyncrasies of the different markets that investors need to take into account when applying factor strategies. There are differences in accounting rules, taxation and local trading peculiarities.
“I would say these are, especially for a factor investor, more nuanced. How can you optimally harvest that factor premium? What’s the best way to extract?” he says.
“Then at the broader level, if you invest in emerging markets, the risk dimension in your factor design is quite crucial because you sometimes have these other risk drivers and governance dimensions,” Baltussen says.
A key example of different risk and governance drivers is the higher share dilution in certain emerging markets, in particular in China and India.
“In China, you will see that the equity issue is way higher, meaning there’s a lot of dilution for the shareholder. As a shareholder, you capture the return of a firm, but if the firm chooses to dilute your stock, your return is far less,” Baltussen says.
“It has been a significant contributor to some of those [lower] returns in emerging markets where the dilution has been way higher,” he says.
“How do you look at shareholder dilution, and can you capture that? This is quite important. Can you capture those firms that have less risk of dilution? Because those firms with less dilution tend to do very well in emerging markets.
“We integrate that, especially into our quality models, and really focus on those emerging market companies that are expected to have stable cash flows, good governance, and stable profitability,” he says.
Inflation and Factors
Baltussen joined Northern Trust Asset Management as Head of Quantitative Strategies, International in November 2023. It is a new role at the company and Baltussen will oversee the firm’s expanding international quantitative teams in Europe, Middle East, Africa and the Asia-Pacific region.
But Baltussen will also continue his research into factors and a current topic of interest is inflation. With inflation still relatively high – although lower than in previous months – the market environment is still precarious.
Also here, we need to look over the long term to make any sense of the influence of inflation on the various factors, Baltussen argues. Not simply back to the last period of high inflation in the 1970s, but all the way back to the 1870s, almost to the start of the industrial revolution.
“To understand inflation, I think it’s quite important to focus really on a long, deep sample,” he says.
Baltussen has looked at episodes of high inflation, defined as periods of sustained inflation above 4 per cent, over the last 150 years.
“This occurred in the last years, including 2023, depending on how you measure global inflation. Before that you had it mostly in the 70s, but that was about it. So when you just have a handful of observations to study high inflation regimes, from a quantitative perspective, that is quite limited.
“So what we did there is go back to 1875, and that’s [a period] where you have a lot of more information and data points on high inflationary regimes.
“Of course, every time it’s a bit different, but the commonality that you see typically with high inflation is that it comes from commodity price spikes or disruptions in supply and demand. In 2021, we have seen that there were disruptions in the supply chain, demand rose a bit, and then you had the mismatch.
Stagflation is what stands out as the worst episodes, where you have double-digit, negative returns on equities in real terms
“Interestingly, often what you see in those episodes is that afterwards deflation comes in. Often, commodity prices tend to go back to close to the original level, or there’s at least some kind of mean reversion. It’s a risk that we also see in China now, although not so much in other markets,” he says.
High inflationary periods are challenging for many traditional asset classes, but for most markets, especially equities markets, the real danger is stagflation – high inflation with hard landings, he says. This is when markets produce some of their biggest losses.
“Stagflation is what stands out as the worst episodes, where you have double-digit, negative returns on equities in real terms,” he says.
Does this mean that you should adjust your portfolio as inflationary regimes change over time?
Baltussen is not convinced this is the right strategy. Although the quality factor tends to perform a bit better than most in high inflationary periods, factors tend to be pretty resilient across most inflationary regimes.
Therefore, a factor balanced approach is a more sensible approach for long term investors.
“It’s quite hard to predict which inflationary state will happen. If you make that call, then you need to have a very high hit rate. That’s typically the kind of bets you try to avoid as a quant investor,” he says.
“And how often do you have a change in the inflationary state? That’s quite uncommon.
“We tend to have more of a risk balanced approach, where you make sure every risk that you take is very well rewarded, and otherwise you don’t take it,” he says.
This article is sponsored by the Northern Trust Asset Management. As such, the sponsor may suggest topics for consideration, but the Investment Innovation Institute [i3] will have final control over the content.
__________
[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.