Our emerging market equity fund is very successful thanks to systematic factor investing.
Dr. Ivan Petzev
Economics
Financial Markets
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Our emerging market equity fund, with its systematic factor investing approach, has been generating significantly above-average returns for many years, and what's more, with below-average risk. What exactly is behind our success with factor investing—and why do emerging markets in particular offer so much potential?
Our emerging market equity fund, with its systematic factor investing approach, has been generating significantly above-average returns for many years, and what's more, with below-average risk. What exactly is behind our success with factor investing—and why do emerging markets in particular offer so much potential?
Factor investing is based on the idea that certain characteristics of equities (known as factors) can be systematically linked to higher risk-adjusted returns. Instead of simply investing in the market as a whole, investors specifically select equities that have certain advantageous characteristics.
The analogy to equities as an asset class is helpful here. The expected returns on equities are higher than those on fixed-income securities such as bonds and cash. Equities are riskier. This is because they are subordinate in the balance sheet. They have a volatile payout profile (dividend/cash flow volatility). In order for investors to invest in equities, they must generate an additional return, known as the equity risk premium, for taking on these risks. Since 1900, US equities have generated a real return of 6.5% p.a., while long-term government bonds have generated only 1.7% p.a. [1]
Analogous to the equity risk premium, an investment in equities with certain characteristics, i.e. factors, is rewarded with a higher (risk-adjusted) return in the longer term. Let's take the factor ‘value’ as an example. Similar to equities vs. bonds, the average returns of value stocks (equities with favourable valuations, e.g. low price-earnings ratios) are higher than those of growth stocks (equities with high valuations, e.g. high price-earnings ratios) over longer periods. Thus, overweighting stocks with attractive valuations leads to outperformance in the medium to long term compared to a purely passive index investment. But where does the value premium of equities come from? There are several explanations, which can be divided into two camps: 1) rational investor behaviour and 2) mispricing by investors due to behavioural patterns.
Rational investor behaviour: Value stocks are less profitable companies; they are generally much more sensitive to economic cycles. These stocks suffer more in a recession. Investors therefore demand a premium for holding these stocks. This unavoidable and therefore systematic risk is compensated for with a premium.[2]
Misvaluation due to behavioural patterns: Investors extrapolate past growth rates too strongly into the future.[3] Value stocks are then priced too low in relation to their earnings potential. The market corrects this misvaluation over time, leading to outperformance of the stocks in the medium to long term. Hype can last a long time, and corrections of mispricing can take just as long (remember the dot-com bubble at the end of the 1990s). The premium that value investors can earn does not come for free: they have to endure a certain amount of underperformance before the mispricing is effectively corrected.
Academics have been debating which explanation is correct for more than 30 years. Ultimately, it is only of limited relevance to investors, as both explanations lead to the same conclusion: investing in value stocks is risky, which is why these stocks must offer a higher expected return (premium), otherwise they would not be in demand. [4] This fact is well documented not only theoretically but also empirically. The value premium exists in various regions and asset classes and has been documented over long periods of time.[5]
Why are factor investments particularly attractive in emerging markets?
Higher risks – higher premiums
On the one hand, systematic risks, i.e. risks that cannot be diversified, for which investors would demand a premium, are more prevalent than in developed markets. Ergo, the required risk premium is higher. Emerging markets are characterised by lower political, structural and legal security. In addition, companies in emerging markets face lower currency stability, greater dependence on the US dollar and an increased risk of liquidity bottlenecks in times of crisis.
Exploiting market inefficiencies
On the other hand, emerging markets are less efficient than developed markets. There are fewer institutional investors, and information is not always priced in immediately. Companies in developed markets are very well covered by financial analysts, and arbitrage opportunities disappear quickly. In emerging markets, on the other hand, companies are analysed by fewer analysts. As a result, mispricings in emerging markets are higher and are corrected less quickly. Finally, investors in emerging markets are more prone to emotionally driven trading (e.g. panic selling, exaggerated euphoria). One example of this is the Chinese stock market, which is heavily influenced by the trading activity of private investors. These investors are often looking for short-term gains and tend to panic sell as soon as the market falls. All of this suggests that mispricing is greater than in developed markets. Therefore, the excess return (premium) in emerging markets should be higher.
Empirically confirmed: higher factor returns in emerging markets
Theory suggests that factor premiums, i.e. factor returns in emerging markets, should be higher over time than in developed markets. This can be confirmed empirically. The chart below shows the performance of long-short factors in developed and emerging markets since 1992. The outperformance of factors in emerging markets compared to factors in developed markets is impressive.
Swiss Rock Emerging Markets Fund: A track record to be proud of
Although long-short factors are difficult to implement in practice (technically speaking, short selling is not possible for most investors, partly due to high transaction costs), the figure above shows how informative factors can be for a long-only investor. By overweighting equities with favourable factor characteristics, they can achieve excess returns relative to the market. The track record of our emerging markets fund, shown in the chart below, confirms this impressively.
The success of systematic factor investing strategies in emerging markets comes as no surprise. A solid theoretical and economic foundation is always the basis for a successful investment strategy. Our factor investing strategy is based on findings from academic and practical research over the last 40 years and has proven itself over many years in very different market environments.
[1] UBS Global Investment Returns Yearbook 2024.
[2] See, for example, Fama, E.F. and French, K.R., 1996, Multifactor Explanations of Asset Pricing Anomalies, The Journal of Finance 51, 55–84.
[3] See, for example, Lakonishok, J., A. Shleifer, and R.W. Vishny, 1994, Contrarian investment, extrapolation, and risk, The Journal of Finance 49, 1541–1578.
[4] The existence of a factor premium due to non-diversifiable systematic risk or mispricing may be relevant to the question of whether the factor premium will continue to exist in the future: investors could adjust their misbehaviour over time, and arbitrageurs could correct mispricing more quickly. However, systematic risk premiums could also disappear if, for example, investors' preferences or risk aversion change.
[5] See, for example, Asness, C. S., Moskowitz, T. J., Pedersen, L. H., 2013, Value and Momentum Everywhere, The Journal of Finance 68 (3), 929–985.
