Rewarded risk factors are recognized as a fundamental component of equity returns. Envestnet | PMC believes that the most 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
Factor performance diverged between domestic and ex-U.S. markets in the third quarter. In the U.S., almost all factors ended below the broad benchmark, whereas abroad all factors ended near or modestly above the relevant index. While momentum was the only positive factor domestically this quarter, it has been a notable laggard year-to-date and over the trailing one-year period thanks to shifting market leadership.
- The value factor once again took a backseat to growthier tech names and was the worst performing factor during the quarter. However, the gap between growth and value closed considerably in the month of September when the market reacted to plans for tapering and rising rates from the Fed. Despite this recent pullback, value has fared well over the trailing year-to-date and one-year period. A strong rally for domestic value over the latter part of 2020 and the beginning of 2021 has resulted in value leading the pack of factors year-to-date and in second place behind small size over the trailing one-year period. Outside the U.S., the value factor has been the best performer over both the year-to-date and one-year periods.
- Small size stocks lagged in the U.S. for the third quarter. Mixed economic data and higher interest rates on the horizon caused many investors to favor large cap names over their riskier small cap counterparts.
- The minimum volatility factor has lagged in both the near- and long-term, which highlights an important nuance between the foundational academic research on factors and their real-world implementation. Academic studies tend to construct factor portfolios such that they have a beta of zero to eliminate exposure to market risk. Conversely, most liquid factor-based portfolios tend to have a beta much closer to one since it is often difficult to construct them in the academic manner due to operational and risk tolerance constraints. This means the beta of most minimum volatility portfolios will be meaningfully higher than zero but below one. While this is a tough hurdle to clear in the quest for outperformance in periods of continually rising markets, this factor’s true usefulness is in providing benchmark-like returns with less risk over the long-term. To that end, it has posted superior risk-adjusted returns over the long-term.
The longer-term performance of the factors presented here demonstrate well what it means to be a factor investor. Like all forms of active management, factors face periods of massive underperformance. However, academic research supports the long-term premia earned by factors as a potentially more reliable way to best the market. It is these premia, and not the stock selection ability of the average active manager, that are the statistically significant source of excess return.
Breaking the momentum
A powerful force
The atmosphere in a stadium packed with tens of thousands of college football fans was shifting with almost electrifying intensity one recent October afternoon. The mood swings were dramatic not only in their fervor, but also in their frequency. As the contest unfolded, home team fans quickly discerned an alarming pattern – seemingly each time their team completed a clutch pass or gashed the defense with a tackle-breaking run, a defender went down with a mysterious injury immediately after the play. The crowd’s jubilant chorus quickly turned sour, as after the game was paused to evaluate the injury, the opposing player hopped up and walked off the field unassisted, leading fans to assume these injuries were faked to stop the home team’s trajectory. The fans and the opposing players almost certainly have a different take on what truly transpired, but whether they were legitimate injuries or strategic gamesmanship, the effect was the same – the home team’s momentum was broken.
The stadium of fans recognized a potent truth. Momentum is a powerful force. Just as it can propel football teams to first downs, it can send the recent best performing stocks even higher. And like faked injuries can slow the fortunes of the home team, market environment changes can stop the momentum factor dead in its tracks.
Shifting leadership
Generally speaking, the momentum factor is designed to follow stocks that have performed well over the near-term, typically over the last twelve-month period and in some cases even shorter timeframes. When market leadership changes rapidly, these portfolios tend to lag, as prior leaders quickly become laggards, and it takes time to recognize and rebalance for these changes. This scenario has plagued the momentum factor recently, plunging its rolling one-year excess return to nearly its lowest point since inception of the index roughly four decades ago.
Over the course of the last year, market leadership shifted dramatically from high growth, large caps to value-oriented and smaller cap names. As a result, momentum indices and portfolios generally made significant reductions to growth-leaning sectors like technology and consumer cyclicals and increased allocations to value sectors like financial services and energy.
The chart below shows shifting allocations for the MSCI USA Momentum Index over the last year. During its second quarter 2021 rebalance, the financials allocation jumped from around 6 percent to over 36 percent, while the technology allocation fell from 35 percent to around 15 percent. This was the largest shift in the financial allocation, which typically makes up about 11 percent of the index, and the second largest shift in the technology allocation, which typically makes up about 21 percent of the index, since inception.
The historically large magnitude of these shifts not surprisingly coincides with the historically large decline in rolling excess return. The quicker and more extreme the shift in market leadership, the more severe will be momentum’s underperformance. However, over the long-term, inflection points of this magnitude have been fewer than directionally rising bull markets, which is critical to the momentum factor earning its premia. Like the home team that overcame some short-term shenanigans to best their opponent, momentum is a factor that has historically overcome short-term shifts on its way to long-term success.
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 U.S. large and mid cap securities exhibiting overall growth style characteristics as measured by five growth variables.
Past performance is not indicative of future results. 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.