Incorporating information imparted by the various economic stages being experienced around the world is useful for investors and sure beats relying on factors’ historical returns. That said, successfully using economic-stage forecasting in factor investing is a complicated process. The Research Affiliates investing approach is based on building simple rules-based factor portfolios. Our experience suggests that the less complicated option of using an investment’s discount and momentum—in this case, the region-factor’s discount and moment—can yield better results. A factor portfolio’s discount is calculated as its current valuation (using the relationship of price to various fundamental measures of the component equities) relative to its average historical valuation. A factor’s momentum is the performance of the factor over the previous 12 months.⁶

Over the last few years we have introduced the investment community to the importance of both valuation and momentum, not just as factors in their own right, but drivers of the return to portfolios of assets. Research by Aked, Mazzoleni, and Shakernia (2016) as well as comprehensive research by Arnott et al. (2021) and Ehsani and Linnainmaa (2019) point to momentum having macroeconomic origins. The pattern of returns for momentum indicates a return source driven by the factor exposure of an asset rather than by the idiosyncratic nature of the asset itself. Additionally, Arnott et al. (2019) weigh in on how important valuation is, even at the factor level. Equity factors that are trading at a significant discount (based on fundamental measures such as book value or sales) versus their long-term average valuation produce larger excess returns moving forward than factors’ trading at premiums to their long-term average valuation.