What is Factor allocation and ow can it help you in frothy markets?

In August, GMO’s James Montier and Matt Kadnar published an article claiming that based on past performance, and valuation, the S&P 500’s total return over the next seven years is likely to be negative.

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Specifically, Montier and Kadnar noted that between 1970 and 30 June 2017, an investment in the S&P 500 produced a real total annual return of 6.3%. Broken down, 3.4% of this return was from dividends with 2.3% from earnings growth. The remained of the return was a result of margin and multiple expansion. However, over the last seven years, margin and multiple expansion have accounted for around half of the S&P 500's average annual return of 13.6%.

Factor Allocation

The GMO analysts note that this performance is unsustainable, and it's only a matter of time before the market's P/E multiple returns to its equilibrium of 16, down from 24.4 currently and profit margins return to the equilibrium of 5.7% compared to the 6.9% currently. A return to these averages gives an estimated annualized total return of -3.9% for the next seven years.

Montier and co-author are not the only ones who believe that equity returns are set to slow in the years ahead as earnings catch up with valuations. Many other analysts and asset allocators hold a similar view, a view that has inspired a rush into private equity funds.

Private equity rush

According to the Financial Times, more than $240 billion has been raised across private equity and venture capital funds in North America and Europe in the seven months to the start of August and at the end of 2016 firms were sitting on a record $739 billion in dry powder.

Unfortunately, private equity may not turn out to be the magic returns generator allocators believe it to be. Analysts at Bernstein point out that the near $1 trillion war chest private equity is now sitting on is a red flag indicating that valuations in the private market are out of control as well, implying lower future returns for private equity as well.

This leads to the question of how should investors allocate their wealth in an environment where all asset classes appear expensive with negative expected real returns?

Factor Allocation

Bernstein's Global Quantitative Strategy team suggests that incorporating factor investing might be the best option. Indeed, in a recent report, the analysts argue that investors need to "get rid of" the "artificial distinction" that exists between asset allocation and factor allocation because, in a world where most assets trade at premium prices, "factors might offer one source of value."

For example, the analysts point out that on absolute terms on a price/book basis (defined as the cheapest quintile of US stocks by price/book) cheap stocks are at the same multiple as they were in the late 80's and on a PE basis the same multiple as they were in 1956. In other words, while the market as a whole is overvalued, there are certain factors that still appear cheap and could hold the key to outperformance.