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INVESTMENT I STRATEGIES n v e s t m e n t A Practical Approach to s Enhancing Investor Returns t r a t e g I e s B i l l J i a n g Bill Jiang Investment Strategies Reviews in alphabetical order of surname “Dr Jiang provides a comprehensive and practical introduction to factor strategies. The book explains the guiding principles behind factor investing with clarity and intuition. Its foundational overview of general and factor investing principles is a good compendium of the literature and a helpful resource to investors and practitioners.” —Jennifer Bender, PhD, Senior Managing Director, Head of Research (Global Equity Beta), State Street Global Advisors “Written by an expert in the field, this book provides an excellent overview of investment strategies that are backed by extensive evidence. Bill Jiang explains key articles written by leading academics in understandable terms, and describes how professional systematic investors apply these concepts in practice.The various topics are discussedinaconcise manner, focusing on themain takeaways,with plenty of references for further reading. I particularly recommend this book to readers unfamiliar with factor investing who are looking for a crash course on the subject.” —David Blitz, PhD, Chief Researcher, Robeco “Dr Jiang’s book represents a major and much needed advancement in the practitioner literature by properly including systematic factor premia and sustainable investing in the spectrum of investment choices. In this era of big data and high-powered computing, our ability to distinguish between compensated and uncompensated risks has not only made portfolio construction more risk-efficient but has opened up a world of possibilities in using factors as building blocks for precision, outcome-oriented strategies. Dr Jiang’s culminating chapter on multi-factor investing represents state-of-the-art thinking in this space.” —Michael R. Hunstad, PhD, Chief Investment Officer, Global Equities, Northern Trust Asset Management “Factor-based investment strategies are important building blocks in modern portfolio management. This book provides a practical overview of popular factor-based strategies employed by institutional investors. It can serve as a useful introduction to factor investing for both university students and investment practitioners.” —Dimitris Melas, PhD, CFA, Managing Director, Global Head of Index Research and Product Development, MSCI “Bill Jiang has written an informative guide to the ‘middle ground’ between active managers and the creators of index-based investment products: factor-based investment strategies. These strategies, in increasingly common use over the last few years, are essential knowledge for both the involved private investor and the young investment professional. By explaining what these strategies are, why they exist, and how they can be implemented, Bill provides the private investor with useful, practical knowledge of how their money is being invested, and the investment professional with a grounding on which to build their skills.” —Gareth Parker, Chief Indexing Officer, Morningstar Bill Jiang Investment Strategies A Practical Approach to Enhancing Investor Returns Bill Jiang Legal & General Investment Management London, UK ISBN 978-3-030-82710-6 ISBN 978-3-030-82711-3 (eBook) https://doi.org/10.1007/978-3-030-82711-3 ©The Editor(s) (if applicable) andThe Author(s), under exclusive license to Springer Nature Switzerland AG 2022 This work is subject to copyright. All rights are solely and exclusively licensed by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply,eveninthe absenceof a specific statement,that such namesare exemptfrom therelevant protective laws and regulations and therefore free for general use. Thepublisher,theauthors,andtheeditorsaresafetoassumethattheadviceandinformationinthisbook are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, expressed or implied, with respect to the material contained herein or for any errors or omissions that may have been made.The publisher remains neutral with regard to jurisdictional claims in published maps and institutional affiliations. Cover credit: RRice/shutterstock.com This Palgrave Macmillan imprint is published by the registered company Springer Nature Switzerland AG The registered company address is: Gewerbestrasse 11, 6330 Cham, Switzerland This book is dedicated to my family: Jessica Jiang Alice Jiang Emily Jiang and the memory of my mother: Xiuping Shi Preface The investment landscape in the modern world continues to evolve in response to technological advances, regulatory requirements and changing market dynamics. Investment models and processes must continually adapt to changes in the increasingly complex and competitive investment environ- ment. Successful investing relies heavily on effective and resilient investment strategies implemented against the backdrop of dynamic market conditions. Investment strategies play a central role in helping investors achieve defined financial objectives. They directly affect investment outcomes and become even more important in times of economic uncertainty and low return expectations across major asset classes. Factor investing has attracted significant investor interest in recent years. This investment approach is positioned between active management and passive investing to combine their advantages. Factor investing seeks to outperform the market with lower investment costs than active strategies. It is designed to capture the return premiums of risk factors in a systematic and efficient way. Factor returns are cyclical in nature and susceptible to market conditions. To harvest factor premiums, some investors adopt factor rotation to actively change factor positions across different economic phases. However, it is practically difficult to detect turning points in the business cycle and reliably predict factor performance. The failure to capture strong factor returns can only result in disappointing investment performance.The emergence of multifactor strategies is a natural development in the evolu- tion of factor investing.The multifactor approach essentially allows investors vii viii Preface to gain balanced and consistent exposure to a combination of factors over time. It provides an effective solution to capture factor premiums and reduce portfolio volatility without the challenging task of factor timing. Factors are systematic drivers of return and the foundation of investment portfolios. Academic and investment studies have identified a range of risk factors in equity investing. Common style factors include size, quality, momentum, value, yield, volatility and liquidity. These factors have proved the ability to generate excess returns over time. The size factor is related to the smallcap effect that smaller companies tend to outperform their larger peers in the long term. It is firmly established in the three-factor model developed by the Nobel Prize winner Eugene Fama and his research partner ProfessorKennethFrench.Thequalityfactorcapturesexcessreturnsdelivered by companies with superior quality characteristics. Quality has been widely adoptedintheinvestmentsectoreitherasafactorstrategyoranelementinte- grated into the investment process. Momentum reflects the observation that share price often continues to move in the direction of a price trend. The momentum strategy aims to produce excess returns by capitalising on established price trends in the market. The value effect refers to the tendency of stockswithattractivevaluationstooutperformthemarketoveralongperiod of time. The value factor outperformed other common style factors during the 40 years to 2017. The yield factor captures excess returns provided by companies with high dividend yields. Dividend yield serves as a style factor andsourceofinvestmentreturn.Thesustainedlowinterest-rateenvironment sincethe2008financialcrisishaspromptedinvestorstoactivelychaseyields. The volatility effect is the phenomenon that stocks with low price volatility tendtogeneratelong-termoutperformance.Itisamarketanomalyinfinance that seriously challenges the prevailing theory stating higher returns require more risk. The liquidity premium compensates investors for holding assets with low liquidity. Investors are encouraged to understand current investment themes and long-term trends in the market for the purpose of strategic asset allocation. Sustainable investing has gained strong market acceptance and continues to rise in prominence. It integrates environmental, social and governance (ESG)standardsintoinvestmentdecisions.ESGissuesareincreasinglyrecog- nised as critical factors that determine the long-term success of companies. The ESG approach provides a framework for the analysis of companies regarding sustainability issues and opportunities. Sustainable investing also allows investors to align personal values with financial objectives. It has become increasingly common for investors to consider ESG criteria in the investment process. MSCI and other leading index providers have launched Preface ix aseriesofESGindicestotracktheperformanceofcompanieswithhighESG scores. Successful investing requires a clear understanding of fundamental investment principles, such as diversification and loss control. Diversification is a simple and effective strategy to mitigate investment risk. It controls exposure to any single asset to protect investment portfolios against disastrous losses in the uncertain market. Diversification reduces portfolio volatility and potentially improves risk-adjusted returns. Investors can construct diver- sified portfolios by allocating capital across different asset classes and risk factors. Investments should be managed as a portfolio rather than individual assets. A disciplined approach is essential to manage losing positions given the prevalence of unprofitable investments in the market. The failure to cut losses quickly can result in severe damage to investment capital. Investors are advised to regularly review portfolios and take decisive actions against companies with deteriorating fundamentals. This book presents a range of investment strategies to help investors enhance return potential. It is primarily written for private investors and investment practitioners such as equity analysts and investment advisors. It is also suitable for university students who are interested in learning practical investmentstrategiesandtraditionalassetclasses.Thebookisstructuredinto 16chapterstodiscussinvestmentapproaches.Chapter1providesanoverview of investment basics, such as risk tolerance and investment constraints. Chapter2discussesassetallocation,investmentvehicles,investmentrisksand performance attribution. Chapter 3 examines the asset class of equities with a specific focus on its risk and return characteristics. Chapter 4 covers bonds andcashastwomajorassetclassesfrequentlyusedtoformthecoreofdefen- sive investment portfolios. Chapter 5 shows the historical performance and investment benefits of precious metals. Chapter 6 illustrates the importance of diversification in investing to reduce downside risk and capture upside returns. Chapter 7 discusses loss control as a key investment principle to protect portfolios against extreme losses. Chapter 8 provides an introduction to sustainable investing regarding its investment objectives, approaches and benefits. Chapter 9 introduces the size effect that smaller companies tend to outperform their larger peers in the long term. Chapter 10 presents quality investing as a widely accepted investment strategy to outperform the market. Chapter 11 examines the momentum effect that excess returns can beearnedbyfollowingpricetrends.Chapter12describesthevalueeffectthat stocks with attractive valuations tend to generate excess returns. Chapter 13 focuses on the discussion of dividend yield as a common style factor and return component. Chapter 14 covers the volatility effect serving as a market x Preface anomaly to challenge the conventional view that higher returns require more risk. Chapter 15 discusses the liquidity premium and the investment risk of holding excessive illiquid assets. Chapter 16 concludes the book with a detailed description of the multifactor investing approach. London, UK Bill Jiang x Disclaimer The MSCI data contained herein is the property of MSCI Inc. (MSCI). MSCI, its affiliates and its information providers make no warranties with respect to any such data. The MSCI data contained herein is used under license and may not be further used, distributed or disseminated without the express written consent of MSCI. S&P® andS&P500® areregisteredtrademarksofStandard&Poor’sFinan- cial Services LLC, and Dow Jones® is a registered trademark of Dow Jones TrademarkHoldingsLLC.©2020S&PDowJonesIndicesLLC,itsaffiliates and/or its licensors. All rights reserved. xi