Quality and value without the side sector bets

Quality and value investment strategies often introduce ancillary sector bets, but it may be prudent to constrain them.

Alex Bryan 25 July, 2017 | 5:00PM

Factor strategies, such as value, low volatility and quality, often end up with industry tilts that can be an unintended source of risk. In March 2017, Morningstar published a study that found that value and low volatility investment strategies exhibited consistent industry tilts that did not significantly contribute to their success. This suggests that investors could reduce active risk without materially sacrificing returns by constraining industry weightings among factor strategies with persistent industry tilts.

To investigate this further, I compared the performance of MSCI's sector-neutral and unadjusted quality and value indexes across several markets. While quality was not covered in the previous study, it exhibits similar persistent sector tilts to value, so it would be reasonable to expect similar results. These indexes represent investable strategies, though much of their data is back-tested.

In addition to constraining their sector weightings, these sector-neutral indexes select stocks based on their factor characteristics relative to their sector peers. Arguably, this approach could lead to better performance than only constraining the sector tilts. Valuations and quality characteristics, like profitability, tend to be more comparable within industries than across them, as firms in the same industry tend to have more-similar balance sheets and business models. Therefore, sector-relative factor characteristics may contain greater information about future expected returns than unadjusted factor data.

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About Author

Alex Bryan

Alex Bryan  Alex Bryan, CFA, is director of passive strategies for North America at Morningstar. Before assuming his current role in 2016, he spent four years as an analyst covering equity strategies. He holds an MBA with high honors from the University of Chicago Booth School of Business.