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
Temperamental investors induced an equity rally in July, fueled mostly by hope alone, before abruptly changing course in August, giving back the early-quarter gains and then some by the end of September. Weaker-than-expected economic growth, continued excessive inflation readings, and an even more hawkish Fed took the early summer wind out of the market’s sails, and the quarter ended with a sinking feeling all around.
All long-only factor indices shown here ended in the red for the quarter and year-to-date periods, driven largely by their exposure to the market factor. However, excess return results varied. For the quarter, small size and momentum showed positive excess returns. For the year-to-date timeframe, value has also posted positive excess return in addition to minimum volatility and small size. The brief risk-on rally in July had an outsized impact on total quarterly performance for the minimum volatility long-only factor, causing its total period return to lag. Outside of July, it has been a top-performing factor for the year-to-date period, as expected in the volatile market environment.
Growth stocks ended ahead of value this quarter, but that was also almost entirely due to the misplaced optimism for a recovery that drove assets into higher growth names in July. Growth lagged value the rest of the quarter and is behind by nearly 15% year-to-date, with the greatest disparity between growth and value seen among large cap stocks. Despite its interruption in July, the rotation to value continues apace domestically and abroad. For the trailing one-year period, it lags only the minimum volatility factor domestically and leads all factors internationally.
The quality factor in a long-only construct continues to confound at the surface level. However, upon a deeper dive, it is clear that other dynamics are at play causing quality to lag in what would presumably be its ideal environment. As we’ve mentioned previously, the market exposure of long-only factor indices has a large impact on performance. As such, the quality factor’s underperformance is tied at least in part to a “baby with the bathwater” rotation away from the high growth technology sector in the overall market. Growth names tend to have better quality characteristics as a whole but underperform when rates are rising. This dynamic is dragging down the long-only iteration of the quality index, even as the quality premia itself is positive.
The momentum factor has struggled to find its footing this year. Momentum falters in non-directional, volatile settings like those experienced this year. There is a notable divergence in small cap performance domestically and abroad year-to-date. Some dominant international economies are in a starker pre-recessionary environment than the US, and investors may be shunning the relative riskiness of smaller names there.
As of 9.30.22. Source: Morningstar Direct, MSCI Inc. U.S. factor returns are represented by the MSCI USA Momentum, MSCI USA Enhanced Value, MSCI USA Quality, MSCI USA Small Cap and MSCI USA Minimum Volatility indices, respectively, and excess returns are relative to the MSCI USA index. World Ex-USA factor returns are represented by the MSCI World ex USA Momentum, MSCI World ex USA Enhanced Value, MSCI World ex USA Quality, MSCI World ex USA Small Cap and MSCI World ex USA Minimum Volatility indices, respectively, and excess returns are relative to the MSCI World ex USA index. These are long-only indices.
The year-to-date performance of these factors offers empirical evidence of their less than perfect correlation, as well as the cyclicality of their return profiles. These characteristics result in a prime opportunity to leverage the benefits of diversification when building a factor strategy. For a deeper dive on this topic, see this quarter’s Factor Insights piece.
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.