Rewarded risk factors are recognized as a fundamental component of equity returns. Envestnet | PMC believes that the more robust among the studied risk factors are value, momentum, quality, low volatility, and size. Like all return components, factors are cyclical in nature. Below, we take a look at the performance of these factors in the current market environment.
How factors have fared
The story so far this year has been the resurgence of value that started at the end of 2020, though the trend has reversed over the last two months
- The quality factor held up relatively well during the market decline early in 2020, and continued that trend during the subsequent recovery and through 2021 so far
- Factor leadership has been volatile this year, with no single factor leading the pack in excess return for more than a month in a row. This is exemplified by the whipsaw performance of the momentum factor, which thrives in directional markets
- Minimum volatility, which disappointed many in the rapid sell-off of the pandemic, has not surprisingly struggled in the general bull market of the last ten years. The expected outcome of this factor is market-like performance with lower risk over the long-term, but its low beta profile may be a headwind in rapidly rising markets. The pace of the market sell-off in early 2020, with its almost indiscriminate effect on all market sectors, coupled with the rapid risk-on recovery through the remainder of the year, left no breathing room for this style to shine
Head fake or here to stay?
The pandemic-fueled sell-off of 2020 was the cherry on top of what had been an epically bad run for value investing over the last ten years (or more or less depending on your personal beliefs regarding the definition of “value”). Investors placed their growth orders in the context of a booming economy and historically low interest rates. This meant high demand for flashy names that offered future growth prospects for which investors were willing to pay up. Meanwhile, value was hardly on the menu.
Value’s recent performance picture is stark. Thirteen of the 20 worst monthly returns for the U.S. value index over the last 20 years were experienced in the last five years alone, and the very worst of them nearly all came from 2020. Conversely, only eight of the better 20 monthly returns were achieved over that same timeframe, and those gains were more than negated by larger losses in that same period. This outcome underscores the volatility of the value factor’s returns. The lure of buying quality assets at an attractive valuation just couldn’t compete with the promise of growth that was so desperately sought by market participants.
But just as all hope seemed to be lost, including by one notable value stalwart who threw in the towel, the pandemic recovery kicked in during the latter part of 2020. Investor appetite shifted along with the economic reopening to focus on those sectors and themes that generally benefit during economic recoveries. In this environment, value has made up some lost ground against the broader market benchmark year-to-date, despite a pullback in June and July.
But we’ve been here before, calling a value rebound that would soon melt away; and perhaps the recent underperformance of value and resurgence of growth preface the start of yet another of these cycles. However, the macroeconomic outlook is on value’s side. The Fed is forecasting higher rates heading into 2022 and 2023, and the potential for higher inflation is on the horizon as the economy absorbs massive amounts of monetary stimulus and consumers resume normal spending. These conditions have historically favored value. Furthermore, simple mean reversion could turn out to be a meaningful tailwind for value. Performance of the factor has trailed the broad universe by a historically wide margin, owing to a performance disparity relative to the growth index that is the widest it has been over the last twenty years.
Hindsight may bring clarity to which path value could take, but what is clearer from this vantage point is the long-term record of the value factor. Dismal intermediate-period performance has certainly been a drag, but history and academic studies suggest it may be an anomalous one.
Glossary
Factor Definitions
- Value: The tendency for cheap assets to outperform expensive assets. (See Basu, S. “Investment Performance of Common Stocks in Relation to Their Price-Earnings Ratios: A Test of the Efficient Market Hypothesis.” Journal of Finance, 1977.)
- Momentum: The tendency for assets that have performed well over the past year to continue to perform well over the near-term. (See Jegadeesh, N and S. Titman. “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency.” The Journal of Finance, 1993.)
- Quality: The tendency for higher quality companies – those that are more profitable and safer – to outperform lower quality companies. (See Novy-Marx, R. “The Other Side of Value: The Gross Profitability Premium.” Journal of Financial Economics, 2013.)
- Minimum Volatility: The tendency for lower beta, less volatile stocks to outperform higher beta, more volatile stocks. (See Ang, A., Hodrick, R. Xing, Y. and X. Zhang. “The Cross-Section of Volatility and Expected Returns.” The Journal of Finance, 2006.)
- Size: The tendency for small capitalization stocks to outperform large capitalization stocks. (See Banz, R. “The Relationship Between Return and Market Value of Common Stocks.” Journal of Financial Economics, 1981.)
Benchmark Definitions
- The MSCI USA Momentum Index is designed to reflect the performance of an equity momentum strategy by emphasizing large and mid-cap U.S. stocks with high price momentum.
- The MSCI USA Quality Index is designed to capture the performance of large and mid-cap U.S. quality growth stocks by identifying stocks with high quality scores based on three main fundamental variables: high return on equity (ROE), stable year-over-year earnings growth and low financial leverage.
- The MSCI USA Minimum Volatility is designed to reflect the performance characteristics of a minimum variance strategy applied to the large and mid-cap U.S. equity universe by optimizing the MSCI USA Index for the lowest absolute risk (within a given set of constraints).
- The MSCI USA Enhanced Value Index is designed to represent the performance of large- and mid-cap U.S. equity securities that exhibit higher value characteristics relative to their peers within the corresponding GICS® sector. The value investment style characteristics are defined using price-to-book, price-to-forward earnings, and enterprise value-to-cash flow from operations.
- The MSCI USA Small Cap Index is designed to measure the performance of the small cap segment of the U.S. equity market.
- The MSCI World ex USA Momentum Index is designed to reflect the performance of an equity momentum strategy by emphasizing large and mid-cap stocks across developed market countries excluding the U.S. with high price momentum.
- The MSCI World ex USA Quality Index is designed to capture the performance of quality growth stocks by identifying stocks of large and mid-cap stocks across developed market countries excluding the U.S. with high quality scores based on three main fundamental variables: high return on equity (ROE), stable year-over-year earnings growth and low financial leverage.
- The MSCI World ex USA Minimum Volatility Index is designed to reflect the performance characteristics of a minimum variance strategy applied to the MSCI large and mid-cap equity universe across developed market countries excluding the U.S. by optimizing the MSCI World ex USA Index for the lowest absolute risk (within a given set of constraints).
- The MSCI World ex USA Enhanced Value Index is designed to represent the performance of large- and mid-cap universe across developed market countries excluding the U.S. that exhibit higher value characteristics relative to their peers within the corresponding GICS® sector. The value investment style characteristics are defined using price-to-book, price-to-forward earnings, and enterprise value-to-cash flow from operations.
- The MSCI World ex USA Small Cap Index is designed to measure the performance of the small cap equity universe across developed market countries excluding the U.S.
- The MSCI USA Growth Index is designed to represent US large and mid-cap securities exhibiting overall growth style characteristics as measured by five growth variables.
The information, analysis, and opinions expressed herein are for informational purposes only and do not necessarily reflect the views of Envestnet. These views reflect the judgment of the author as of the date of writing and are subject to change at any time without notice. Nothing contained in this piece is intended to constitute legal, tax, accounting, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type.
Written By:
Sarah Abernathy, VP, Senior Investment Analyst, Envestnet
Sarah Abernathy, CFA, CAIA, has spent her career assisting RIA, bank, and broker dealer home office clients and their advisors with money manager research, due diligence, and selection, as well as advising on asset allocation, capital market assumptions, and tax optimization. Mss. Abernathy holds a bachelor’s degree with dual majors in Finance and Economics, and a minor in Spanish, from the University of Northern Iowa. She has earned the CFA and CAIA charters, and is a member of the CFA Institute, the CFA Society of Iowa and the CAIA Association.