LR30230

Lazard Perspectives

Who Will Survive the Market Regime Shift?Investors have flocked to passive equity strategies over the past two decades amid impressive market returns and unusually depressed levels of volatility. However, the tide could turn on index-tracking strategies, as market conditions become more variable after a prolonged period of stability. We believe this will place a renewed focus on active fundamental strategies and approaches that exploit persistent drivers of returns.

2

What to Expect as the Market Cycle TurnsGlobal equity markets have been in a nine-year bull run, the second-longest in history, accompanied by strong corporate profits, low inflation, and extremely accommodative central bank policy. Stock valuations have become stretched by historical standards and investors are starting to question whether equity market returns generated in recent years can be sustained as the market cycle matures.

The divergence between active and passive fund flows has widened to extreme levels (Exhibit 1). Meanwhile, valuations of equity markets have become stretched at a time when major global central banks are looking to normalise monetary policy. We believe these skewed valuations are due to market inefficiencies that could eventually unsettle markets. In that scenario, active investment strategies may perform better than index-tracking approaches as stock pickers are able to take advantage of opportunities in ways that passive strategies cannot.

Analysis shows that when stock market valuations are close to historical highs, the outlook for future returns diminishes. Prior to the sharp sell-off at the start of 2018, the S&P 500 Index’s forward price-to-earnings ratio—which measures current prices against consensus expectations for future earnings—was close to a 16-year high. When using economist Robert Shiller’s cyclically adjusted price-to-earnings (CAPE) ratio, which accounts for inflation, equity markets appear to be even more overvalued. The Shiller CAPE ratio reached levels in January 2018 that have only been exceeded by valuations just prior to the 2000 tech bubble.

Analysis of long-term equity returns, based on the work of Shiller and the Yale School of Management, demonstrates that rising equity market valuations tend to be followed by lower returns (Exhibit 2). The more valuations become stretched, the more

future returns are compressed. The CAPE ratio of the S&P 500 Index has remained above 30 since July 2017, suggesting that expectations of future market returns are likely to moderate.

Assuming the same relationship holds for other equity markets, a similar global picture emerges (Exhibit 3). Few markets currently trade at a discount compared to their long-term averages, suggesting that market returns globally are likely to moderate in the coming years, again raising questions around the merits of passive investment strategies.

Exhibit 1Are Passive Fund Flows Reaching a Tipping Point?

Global Mutual Fund Flows

-3,000

-2,000

-1,000

0

1,000

2,000

3,000

4,000

2018201520122009200620032000

(USD bn)

Active Passive

As of 28 February 2018

Source: Bernstein

Exhibit 2Stretched Valuations Tend to Compress Future Returns

0

5

10

15

20

Median

Greater than 30x

25x–30x20x–25x15x–20x10x–15x5x–10x

Average Forward Compound Annual Growth Rate (%)

Shiller P/E

As of 31 December 2017

The Shiller CAPE ratio is calculated by dividing the end of day price of the S&P Composite (between 31 January 1871 and 31 December 2017) by its average inflation adjusted earnings over the previous 10 years. Valuations over this period have been ranked from highest to lowest and divided into six groups. The average seven-year forward return was calculated for each of the six groups and then annualised to calculate the compound annual growth rate.

Source: Lazard, S&P Dow Jones Indices, Yale University

Exhibit 3Many Key Markets Appear Overvalued

-10

-5

0

5

10

15

20

25

Pan Asia Developed

Markets ex-Japan

JapanEmerging Markets

UKEurope ex-UK

US

Valuation Premium/Discount (%)

All Caps Large Caps

As of 31 March 2018

This analysis is conducted using price-to-book, EV/EBITDA (excluding financials), and price-to-earnings ratios. The premium or discount across each of these three metrics is averaged for each market, across every year from 1989 to the present year. For each valuation metric, the average valuation of the median ranked stock in each region/country index from the most recent data set is compared against the average valuation of the median ranked stock for every year since 1990 (for emerging markets this has been calculated for every year since 1996). The S&P Global BMI and the S&P Global LargeMidCap indices have been used to represent the regions and countries above, except the UK, which is represented by the FTSE 100 and FTSE All-Share indices.

Source: Lazard, FTSE Group, S&P Dow Jones Indices

3

Searching for Alpha If future returns across a number of equity markets are expected to moderate—and result in muted gains among the passive strategies that track them—then generating returns capable of meeting investor targets will likely become even more challenging. In such an environment, we believe that factor investing could unearth some compelling opportunities for investors that are seeking consistent long-term returns.

Research from Lazard’s Equity Advantage team suggests that certain investment styles tend to perform more strongly when equity market valuations are relatively rich. Of the four most widely recognised factors (value, momentum, growth, and quality), the team’s research shows that momentum investing is more effective when equity markets are expensive relative to long-term averages, while value investing is more effective when equity markets are cheap (Exhibit 4).

The current drawdown in value, which started in July 2007, has wrong-footed many investors (Exhibit 5). Since then, equity markets have spent the majority of the time trading at a valuation premium compared to historical norms. To illustrate this, US equities have been trading at above-average valuations over this period (identified by Shiller CAPE ratios within the top third of multiples by historical standards) 77% of the time. We believe that the strong link between factor returns and market valuations explains this prolonged underperformance of value and, indeed suggests, that it could have been anticipated. Furthermore, it also explains the strong performance of momentum indices in recent years.

Gaining a “Structural Edge” While our research shows a strong link between factor returns and equity market valuations, a number of other dynamics, including macroeconomic developments, can influence factor returns over the long term.

Academic research across the four factors reveals that they are highly cyclical in nature. Value factor returns were exceptional in the early 2000s, while more recently, the performance of this factor has moderated and returns from growth and sentiment have been consistently strong (Exhibit 6). However, in aggregate,

the four investment styles have delivered positive returns over the long term and this suggests that managers with a style bias could potentially face strong headwinds if their preferred investment style falls out of favour.

The relationship between the performance of different investment styles and market valuations is likely explained by the way investors perceive and price different market risks. In relatively cheap markets, investors tend to be more risk averse and generally either expect a greater premium for the risk undertaken or more certainty from their investments. In relatively expensive markets, investors tend to be more relaxed about the potential risks to corporate profits, and the risk premium compresses. The higher risk premium applied to

Exhibit 4Momentum Fares Better in Rich Markets

Style (Fama French 1927–2018) Value Momentum

Market Valuation (top/bottom tertile) Cheap Expensive Cheap Expensive

Annualised Factor Return (%) 7.57 4.42 7.30 10.81

As of 31 January 2018

The value and momentum factor returns from the Fama-French data library have been calculated for the periods when the S&P 500 Index was relatively cheap and also relatively expensive by historic standards. Cheap and expensive periods are defined by Shiller CAPE ratios that are in the bottom and top tertiles, respectively.

Source: Lazard, Dartmouth University

Exhibit 5Value Has Endured a Lengthy Drawdown

-35

-30

-25

-20

-15

-10

-5

0

2016200920021995198819811974

Drawdown from Previous High (%)

As of 31 March 2018

Source: MSCI

Exhibit 6Factor Performance is Cyclical

100

80

60

40

20

0

-20

-40

-60

-80

-1001996 2000 2004 2008 2012 2016

Return (%) Value Growth Sentiment Quality

As of 31 December 2017

The average quintile spread is calculated quarterly for each factor group. Value is the average factor performance of P/B, P/E, and dividend yield of stocks in the S&P Global BMI Index. Growth is the average of five-year sales and earnings growth, and projected three-year sales and earnings growth. Sentiment is the average of stock returns (on a total return basis) over 12 months and three-month change in analysts’ consensus earnings estimates. Quality is the average of net margins, ROE, and debt-to-equity.

Source: Lazard, FactSet, S&P Dow Jones Indices

4

stocks in relatively inexpensive markets offers active managers a fertile ground of mispriced assets, securities that are unloved and underappreciated by the broader market. In relatively expensive markets where risks are not as keenly priced, investors tend to flock to assets that have performed well, resulting in a momentum-driven, not valuation-driven, market environment.

We believe that a systematic approach that maintains a consistent and balanced exposure to factors over market cycles generates predictable excess returns. Furthermore, correlations between the returns to different investment styles are low (Exhibit 7) highlighting the diversification benefits of having exposure to a combination of styles.

Consistent and balanced exposure across these proven factors generates an abundance of opportunities for managers not constrained to a particular style or styles from which to source returns, which is a structural advantage.

The Importance of GrowthWhile many quantitative managers employ a series of factors to identify excess returns over time, growth is not typically one of them. We believe this is because few quantitative managers have identified approaches that isolate and exploit growth successfully. When defined correctly, we believe growth can deliver alpha, particularly in favourable growth environments, and defend well in non-growth environments. As such, we believe it is an important component of delivering consistent returns.

As previously mentioned, the current style regime has resulted in a prolonged period of underperformance of value stocks. Conversely, growth stocks have outperformed in these market conditions. From the end of 2012 through to the end of March 2018, the MSCI World Growth Index has outperformed the MSCI World Index by over 10%. However, despite this outperformance, the long-term returns derived from growth investment styles tend to be relatively unattractive.

We believe that this ultimately ties back to using poor methodologies in identifying growth stocks. Growth investors often place a greater emphasis on a narrow set of investment

metrics, such as forecast earnings or sales growth, to identify attractive growth stocks. This runs the risk of pointing investors towards “glamour” growth stocks. These “hot” stocks rise in popularity but then tend to under-deliver on expected earnings growth, leading to poor stock price performance.

In our view, a broader and more discriminating approach is more effective in assessing growth stocks. This relies less on growth metrics alone and moves towards a deeper appraisal of the drivers of growth. An aggregation of important, yet often overlooked, indicators that require nuanced interpretation in financial statements can offer differentiated insights into how a business is developing. This alternative to forecasting future earnings and sales growth can identify stocks that offer strong returns in growth environments and deliver returns that are more defensive when growth stocks fall out of favour with investors (Exhibit 8).

The Building Blocks of Consistent ReturnsA deep understanding of the cyclical nature of style returns has important investment implications, particularly for those investors seeking more predictable outcomes and smoother return patterns. We believe the key is to identify investment metrics that perform well when the investment style to which they are most closely associated is not only in favour but, more crucially, also when it falls out of favour.

Understanding the nuances of how different stocks behave in different market environments is an important consideration in assessing how the portfolio might perform more broadly. Part of this is knowing how very strong (or weak) market returns may affect the performance of different types of stocks, as well as how certain stocks might be affected by the prevailing investment style, and sudden and sharp changes to broad investor risk appetite. A thorough understanding of the impact of investors’

Exhibit 7Styles Behave Independently of One Another

Correlation of Returns (%)

Quality Sentiment Growth Value

Value 13 -22 -52

Growth 35 4

Sentiment 52

Quality

As of 31 December 2017

The correlations between styles is calculated by comparing the monthly factor returns for each style group as defined in Exhibit 6. The correlation of the monthly time series of factor returns is calculated for each style pair.

Source: Lazard, FactSet, S&P Dow Jones Indices

Exhibit 8Lazard’s Advantage Growth Factor Has Outperformed Its Naïve Counterpart

MSCI Growth Outperforms MSCI World Information Ratio

Naïve Growth Factor 1.31

Advantage Growth Factor 1.78

MSCI Growth Underperforms MSCI World Information Ratio

Naïve Growth Factor -0.80

Advantage Growth Factor -0.27

From 31 December 1995 to 31 March 2018

Data shows the information ratio of the monthly quintile spread of the Lazard Equity Advantage growth factor and naïve growth factor. The naïve growth factor is the average quintile spread of five-year earnings growth and five-year sales growth investment metrics. The information ratio is calculated when the MSCI Growth Index outperforms and underperforms the MSCI World Index. The universe of stocks used to calculate information ratios is the S&P Global LargeMidCap Index.The information ratio is calculated by multiplying the quintile spreads by the square root of 12 and dividing by the standard deviation of the quintile spreads.

Source: Lazard, MSCI, S&P Dow Jones Indices

5

behavioural biases, combined with the expected return pattern of the chosen investment metric is, in our view, crucial to the bottom-up stock picking process. We view the combination of these market insights as the building blocks to generating a consistent pattern of portfolio returns over the long term. Indeed, a well-selected set of researched investment metrics has created a more favourable performance profile versus naïve metrics by generating strong returns when a given investment style is in favour and defending well when it is not (Exhibit 9).

For bottom-up active managers not restricted to any one particular style, this creates a more rounded and complete approach to stock selection that generates richer sources of opportunity. This is because mispriced stocks can be unearthed from the entire investment universe, rather than from a subset of the universe that is ultimately constrained by a certain style bias. Moreover, the appraisal of a stock from multiple style perspectives gives rise to a more balanced stock selection approach, as an exposure to all of the widely acknowledged style groups can be achieved at the portfolio level.

When making security selection decisions in this way, only a select group of companies will appear favourable versus their peers regardless of which of the four investment styles are being assessed. It is here, where we believe the “star” stocks that are truly mispriced in the context of broader investor style preferences can be found. We believe those stocks that look attractive from two or three investment perspectives ultimately offer sources of consistent returns at the portfolio level, as these act as “style hedges”. As investor preferences change, the stocks held that represent the newly favoured investment styles begin to attract investor attention, while the stock positions that reflect the waning investment style weaken moderately as they are supported by fundamentals and sentiment.

The Advantages of Quant Approaches Rooted in Fundamental Analysis The principal skill of a style-agnostic investor is to be, at all times, open to how aggregate investor behavioural biases create stock mispricings, particularly when in the midst of changing economic and market environments. A systematic technique that builds in-depth company analysis into the investment process can further enhance a portfolio’s return. Thus, industry characteristics can be mapped more closely to characteristics that active managers perceive to be important, enhancing the way in which stocks are systematically evaluated. We believe the Lazard Equity Advantage team—a quantitatively driven investment team that focuses on actively managing portfolios based primarily on fundamental bottom-up research—is uniquely positioned relative to other quantitative researchers and portfolio managers. We seek more complex market mispricing opportunities—those that are fundamentally identified but systematically exploited.

If global equity market returns moderate, there is a strong possibility this will cause investors to reconsider their passive equity allocations and renew interest in active strategies designed to outpace the market. While empirical evidence has demonstrated that exploiting certain factors can reward investors over the long term, the meticulous construction and implementation of factor-based strategies is crucial in determining the eventual success of such strategies. Naïve factor-based approaches could introduce some of the weaknesses inherent in passive strategies, including lengthy drawdown periods, style drift, unintended biases, and opacity around the drivers behind a factor’s excess returns, as we explain in Six Sins of Smart Beta.

Style-agnostic investors who have a deep understanding of how style tilts influence returns in a portfolio of stocks can take advantage of style biases to deliver more consistent active returns. Incorporating the inputs and insights derived from rigorous fundamental analysis aids in this endeavour. The Lazard Equity Advantage team combines fundamental analysis with a systematic investment process to actively navigate regime shifts, seeking to prosper in unsettled market conditions and enhance long-term returns.

Exhibit 9Lazard’s Other Advantage Factors Have Also Outperformed Their Naïve Counterparts

MSCI Quality Outperforms MSCI World Information Ratio

Naïve Quality Factor 2.59

Advantage Quality Factor 2.06

MSCI Quality Underperforms MSCI World Information Ratio

Naïve Quality Factor -1.06

Advantage Quality Factor 0.40

MSCI Value Outperforms MSCI World Information Ratio

Naïve Value Factor 1.97

Advantage Value Factor 2.40

MSCI Value Underperforms MSCI World Information Ratio

Naïve Value Factor -0.49

Advantage Value Factor -0.21

MSCI Momentum Outperforms MSCI World Information Ratio

Naïve Momentum Factor 3.35

Advantage Momentum Factor 3.51

MSCI Momentum Underperforms MSCI World Information Ratio

Naïve Momentum Factor -1.75

Advantage Momentum Factor -1.10

From 31 December 1995 to 31 March 2018

Data shows the information ratio of the monthly quintile spread of the Lazard Equity Advantage quality, value, and momentum factors compared to naïve quality, value, and momentum factors. The information ratio is calculated from periods when the MSCI style index outperforms and underperforms the MSCI World Index. The universe of stocks used to calculate information ratios is the S&P Global LargeMidCap Index. The information ratio is calculated by multiplying the quintile spreads by the square root of 12 and dividing by the standard deviation of the quintile spreads. The naïve quality factor is an equally weighted combination of high return-on-equity , high margin and low leverage stocks. The naïve value factor is an equally weighted combination of P/B, P/E and dividend yield metrics. The naïve momentum factor is an equally weighted combination of 12-month price momentum and 3-month change in analysts' estimates.

Source: Lazard, MSCI, S&P Dow Jones Indices

6

This document is provided by Lazard Asset Management LLC or its affiliates (“Lazard”) for informational purposes only. Nothing herein constitutes investment advice or a recommenda-tion relating to any security, commodity, derivative, investment management service, or investment product. Investments in securities, derivatives, and commodities involve risk, will fluctuate in price, and may result in losses. Certain assets held in Lazard’s investment portfolios, in particular alternative investment portfolios, can involve high degrees of risk and volatil-ity when compared to other assets. Similarly, certain assets held in Lazard’s investment portfolios may trade in less liquid or efficient markets, which can affect investment performance. Past performance does not guarantee future results. This document is intended only for persons residing in jurisdictions where its distribution or availability is consistent with local laws and Lazard’s local regulatory authorizations. The Lazard entities that have issued this document are listed below, along with important limitations on their authorized activities. Australia: Issued by Lazard Asset Management Pacific Co., ABN 13 064 523 619, AFS License 238432, Level 39 Gateway, 1 Macquarie Place, Sydney NSW 2000, which is licensed by the Australian Securities and Investments Commission to carry on a financial services business. This document is intended for wholesale investors only. Canada: Issued by Lazard Asset Management (Canada) Inc., 30 Rockefeller Plaza, New York, NY 10112 and 130 King Street West, Suite 1800, Toronto, Ontario M5X 1E3, a registered portfolio manager providing ser-vices to non-individual permitted clients. Dubai: Issued and approved by Lazard Gulf Limited, Gate Village 1, Level 2, Dubai International Financial Centre, PO Box 506644, Dubai, United Arab Emirates. Registered in Dubai. International Financial Centre 0467. Authorised and regulated by the Dubai Financial Services Authority to deal with Professional Clients only. EU Member States: Issued by Lazard Asset Management (Deutschland) GmbH, Neue Mainzer Strasse 75, D-60311 Frankfurt am Main. Hong Kong: Issued by Lazard Asset Management (Hong Kong) Limited (AQZ743), One Harbour View Street, Central, Hong Kong. Lazard Asset Management (Hong Kong) Limited is a corporation licensed by the Hong Kong Securities and Futures Commission to conduct Type 1 (dealing in securities) and Type 4 (advising on securities) regulated activities only on behalf of “professional investors” as defined under the Hong Kong Securities and Futures Ordinance (Cap. 571 of the Laws of Hong Kong) and its subsidiary legislation. Korea: Issued by Lazard Korea Asset Management Co. Ltd., 10F Seoul Finance Center, 136 Sejong-daero, Jung-gu, Seoul, 100-768. People’s Republic of China: Issued by Lazard Asset Management. Lazard Asset Management does not carry out business in the P.R.C. and is not a licensed investment adviser with the China Securities Regulatory Commission or the China Banking Regulatory Commission. This document is for reference only and for intended recipients only. The information in this document does not constitute any specific investment advice on China capital markets or an offer of securities or investment, tax, legal or other advice or recommendation or, an offer to sell or an invitation to apply for any product or service of Lazard Asset Management. Singapore: Issued by Lazard Asset Management (Singapore) Pte. Ltd., 1 Raffles Place, #15-02 One Raffles Place Tower 1, Singapore 048616. Company Registration Number 201135005W, which provides services only to “institutional investors” or “accredited investors” as defined under the Securities and Futures Act, Chapter 289 of Singapore. United Kingdom: Issued or approved by Lazard Asset Management Ltd., 50 Stratton Street, London W1J 8LL. Registered in England Number 525667. Authorised and regulated by the Financial Conduct Authority (FCA), providing services only to persons classi-fied as eligible counterparties or professional clients under the rules of the FCA. United States: Issued by Lazard Asset Management LLC, 30 Rockefeller Plaza, New York, NY 10112.

LR30230

Important InformationPublished on 5 June 2018.

Information and opinions presented have been obtained or derived from sources believed by Lazard to be reliable. Lazard makes no representation as to their accuracy or completeness. All opinions expressed herein are as of the published date and are subject to change.

Certain information included herein is derived by Lazard in part from an MSCI index or indices (the “Index Data”). However, MSCI has not reviewed this product or report, and does not endorse or express any opinion regarding this product or report or any analysis or other information contained herein or the author or source of any such information or analysis. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any Index Data or data derived therefrom.

FTSE International Limited (“FTSE”) © FTSE [2018]. “FTSE®” is a trade mark of the London Stock Exchange Group companies and is used by FTSE International Limited under licence. All rights in the FTSE indices and / or FTSE ratings vest in FTSE and/or its licensors. Neither FTSE nor its licensors accept any liability for any errors or omissions in the FTSE indices and / or FTSE ratings or underlying data. No further distribution of FTSE Data is permitted without FTSE’s express written consent.

The S&P Index (“Index”) is a product of S&P Dow Jones Indices LLC and/or its affiliates and has been licensed for use by Lazard Asset Management LLC. Copyright © 2018 by S&P Dow Jones Indices LLC, a subsidiary of the McGraw-Hill Companies, Inc., and/or its affiliates. All rights reserved. Redistribution, reproduction and/or photocopying in whole or in part are prohibited without written permission of S&P Dow Jones Indices LLC. For more information on any of the S&P Down Jones Indices LLC’s indices please visit www.spdji.com. S&P® is a registered trademark of Standard & Poor’s Financial Services LLC and Dow Jones® is a registered trademark of Dow Jones Trademark Holding LLC. Neither S&P Dow Jones indices LLC, Dow Jones Trademark Holdings LLC, their affiliates nor their third-party licensors make any representation or warranty, express or implied, as to the ability of any index to accurately represent the asset class or market sector that it purports to represent and neither S&P Down Jones Indices LLC, Dow Jones Trademark Holdings LLC, their affiliates not their third-party licensors shall have any liability for any errors, omissions, or interruptions of any index or the data included therein.

This content represents the views of the author(s), and its conclusions may vary from those held elsewhere within Lazard Asset Management. Lazard is committed to giving our investment professionals the autonomy to develop their own investment views, which are informed by a robust exchange of ideas throughout the firm.

About the Team

The Lazard Equity Advantage team believes that core exposure is best maintained through a systematic approach that avoids overweights to styles, sectors, or industries in relation to the benchmark. Using a proprietary investment process, the team selects companies that it believes offer attractive fundamentals and high-quality financial characteristics.

The team joined Lazard in 2008, and today it manages a range of benchmark-aware global and regional systematic equity strategies and low-risk global equity strategies. The team consists of 11 investment professionals with 21 years of industry experience, on average. As part of their process, they draw upon Lazard’s global research platform and they benefit from the firm’s infrastructure, which includes risk management and operations support.