Factor in Market Uncertainty in Portfolio Construction
The start of 2020 has been a year that no one could have imagined.
Including a multi-factor strategy in your portfolio provides increased diversification and may potentially improve consistency in the overall portfolio performance
Getting Caught Off-guard: The 2020 Hindsight
The start of the new decade began with a sense of optimism. Having contended with the Australian bushfires and floods the worst seemed over or at least we thought. Until, the emergence of COVID-19. COVID-19 was initially reported on the 31 December 2019 where the world thought at this point in time it was a China specific issue. Yes, supply lines were going to be disrupted but expectations were that before too long factories and manufacturing would re-open.
Move forward three months and the world is in lockdown as the virus has spread and COVID-19 is now a global pandemic. China for now seems to be coming out the other side while the rest of the world is still getting to grips with the devasting effects of this virus. In response to the disruption, a breakdown in oil talks and continued uncertainty around growth and company earnings, equity markets have sold off close to 30% over the first quarter of 2020. Governments and central banks have thrown their usual ammunition but given the world is dealing with a highly contagious and deadly virus, this is an economic band aid. Subsequently the risks across markets increase, with volatility across equity markets spiking to record highs while spreads of debt have ballooned.
Now is the time where investors need to lean on their portfolios for diversification. Even within asset classes including equity allocations where investors are encouraged to consider diversification across factor exposures.
The Multi-Factor Difference
Factor investing, also called smart beta, generally refers to a category of rules-based approaches to investing. These strategies seek to capture specific factors, or investment characteristics such as value and quality. Academic research has documented long-term outperformance of factors. Over the short-term, the performance of single factors can be cyclical, and individual factors can experience periods of underperformance relative to market cap weighted indices.
The SPDR® MSCI World Quality Mix Fund (QMIX) is an equally weighted combination of three factor indexes:
MSCI World Value Weighted Index - The value index overweights companies with attractive fundamental ratios like Price/Book, Price/Earnings, Price/Cash Flow and Dividend Yield. Of late, these companies have tended to be of poorer quality and have had slightly higher volatility.
MSCI World Minimum Volatility Index - The low volatility index is the lowest risk portfolio MSCI can build. MSCI assesses the risks of each individual company and the risk of different combinations of companies in designing the index.
MSCI World Quality Index - Quality companies are those with high and stable profitability, and low leverage. These companies with high and stable profitability, and low leverage tend to be very large and also very expensive by most traditional accounting measures..
Each of these indices has distinctive characteristics in relation to styles, countries and industries. It is the complementary nature of these three underlying indices that makes QMIX such a strong core equity holding for a multi-asset portfolio such as the State Street ETF Model Portfolios.
Has Diversification Worked for QMIX Investors in Q1 2020?
We used a cut-off of 0.25% to highlight ‘material’ outperformance and noted months where each factor outperformed (˄) versus the MSCI World Index, underperformed (˅) or was within +/- 0.25% (>) for the first quarter of 2020.
In January 2020, COVID-19 hadn’t yet taken a grip outside of China. Markets were still posting positive returns with the MSCI World Index up +4.36%. QMIX outperformed the broad market by +14 bps, with +4.50%. Performance for QMIX was driven by both the minimum volatility and quality. However, value continued to detract and underperformed relative to the broad market.
February 2020 returns were impacted by the strong sell-off at the end of the month as the global impact of COVID-19 came into effect. Negative returns were seen across the board with the broad market down -4.95% and QMIX down almost the same -4.98%. Again, minimum volatility and quality beat the market, declining less but value continued to underperform.
March 2020 experienced sell-off across markets and more dispersion in returns. The MSCI World Index was down -8.60% but QMIX outperformed despite being down -7.76%. Quality was the most resilient in the downturn -3.82% while minimum volatility also managed to outperform the broad index and was down -6.38%. However value continued to underperform down almost -12.5% for the month.
Overall for the quarter, QMIX and its balanced exposure across factors has outperformed the broad market by over 1%
Using QMIX in a Multi-Asset Portfolio
So where does a product like QMIX fit into a portfolio? QMIX aims to exploit portfolio characteristics that we believe will provide superior returns over very long periods, especially when adjusted for risk. For this reason QMIX is utilised as the world allocation in the State Street ETF Risk based Model Portfolios .
The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA’s express written consent.
The views expressed in this material are the views of the State Street Global Advisors ETF Model Portfolios Strategists through the period ended March 30, 2020 and are subject to change based on market and other conditions. The opinions expressed may differ from those with different investment philosophies.
This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
Companies with large market capitalizations go in and out of favor based on market and
economic conditions. Larger companies tend to be less volatile than companies with smaller market capitalizations. In exchange for this potentially lower risk, the value of the security may not rise as much as companies with smaller market capitalizations.
Investments in mid-sized companies may involve greater risks than in those of larger, better known companies, but may be less volatile than investments in smaller companies.
Investing in foreign domiciled securities may involve risk of capital loss from unfavorable fluctuation in currency values, withholding taxes, from differences in generally accepted accounting principles or from economic or political instability in other nations.
Investments in emerging or developing markets may be more volatile and less liquid than investing in developed markets and may involve exposure to economic structures that are generally less diverse and mature and to political systems which have less stability than those of more developed countries.
Risks associated with equity investing include stock values which may fluctuate in response to the activities of individual companies and general market and economic conditions.
A “quality” style of investing emphasizes companies with high returns, stable earnings, and low financial leverage. This style of investing is subject to the risk that the past performance of these companies does not continue or that the returns on “quality” equity securities are less than returns on other styles of investing or the overall stock market.
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