Using a factor framework to identify drivers of performance helps us explore the issue of whether active UK managers have a bias to size or any other factors, explains Francis Chua, Fund Manager at Legal & General Investment Management.
Investing in active UK equity managers has sometimes been considered synonymous with investing in UK small-caps. The small-cap effect has been discussed before, notably by my colleague Justin Onuekwusi here, so I won’t repeat the theory behind it. Instead, I will explore the factor landscape of active UK equity managers.
Have you ever wondered if their exposure to size has been persistent across time? If it is, this would suggest that managers will lean on the small-cap premium regardless of economic regime. Our analysis of the manager universe shows that the exposure to size has indeed been a persistent factor across time and has been increasing over the past five years. Using a multivariate regression on monthly returns, we analyse contributions to manager excess returns from factors, shown in the chart below. The bars represent contribution to excess return from each factor; for instance, in 2009 roughly 40% of each unit of excess return is attributable to quality (investing in stocks with higher profitability and less debt) and roughly 25% to size.
In 2019, for the first time, we see size as the most influential factor for the ‘average’ active UK equity manager. The persistence of size across time supports the narrative that moving down the market-cap spectrum is an alpha lever regularly used by managers.
We also see that exposure to the size factor has increased over time. This could be an indication that there is greater confidence in taking on higher risk, but it is more likely that this is the result of sector positioning by managers today (for instance, being underweight the energy sector and overweight consumer discretionary names).
The chart is also interesting in that it shows the absence of value (investing in ‘cheap’ companies, as measured against their fundamental metrics); are there any value managers left in the UK?
A different picture without size
The reason value is missing from the chart above is because its effect is dominated by size. To put this differently, value managers also invest in small-caps and the size effect dominates the overall analysis. Repeating the analysis and excluding size, this time we see value become more prominent.
The number of value managers has grown, both in absolute terms and as a proportion of the active-manager universe. Our analysis shows that in 2009, 61 managers had exposure to value, roughly 43% of the universe. In 2019, the number of managers with exposure to value jumps to 150, which is nearly a 250% increase in absolute terms. The number of managers in the universe has also increased over the past 10 years, so as a proportion this works out to be 67%. Today, more than half of the active-manager universe offers exposure to value, but note that nearly all of these value managers will have a bias to size (if you’re interested, our analysis suggests only six value managers today don’t have exposure to size). As our first chart above shows, the effect from size will likely dominate exposure to value.
Missing low volatility?
For any investor concerned about recession, we see two possible options in the UK equity market: increase exposure to quality and/or to low volatility (investing in stocks with smaller price moves). From the charts above, we see quality has been a mainstay of active UK equity managers.
What about low volatility? Similar to value, over the past 10 years we’ve seen an increase in exposure to low volatility; in 2009 a mere 8% of the managers had statistically significant exposure to low volatility, while today the number is closer to 21%. Nonetheless, it remains the least influential factor, in terms of its impact on performance, amongst active UK equity managers.
Implications for manager selection
Getting exposure to low volatility as a factor is possible, but requires investors to cast the net wider and also potentially accept other incidental exposure to factors such as quality and value. By our estimates, 75% of managers offer exposure to more than one factor (outside size). Single-factor managers, the size factor aside, are thus a smaller part of the universe.
Returning to the point about size, investors should bear in mind that whichever factor exposure they seek, there is likely to be an inherent size bias. As we’ve shown in the first chart, the effect from size could dominate the risk and/or return of their investments; in the context of the overall portfolio, this should be taken into account.
The active UK equity manager universe offers exposure to a range of factors, and building a portfolio through a factor lens helps to identify drivers of performance and also aids portfolio construction.
If you’re looking for a refresher on factor-based investing, you can read this piece by Andrzej Pioch here.
This article has first been published on macromatters.lgim.com.