Understanding Factor Cyclicality

Drivers of Return in Global Equity Markets

Research suggests that returns in global equity markets are largely driven by factors—well understood and persistent characteristics of stocks. At SSGA, we focus on the factor premia that have a well-documented history in academic literature as well as a strong and sustainable economic rationale for their existence. For equities, these factors are Value, Size, Low Volatility, Quality and Momentum.

Value
Inexpensive stocks tend to outperform more expensive stocks

Size
Stocks of small companies tend to earn greater returns than stocks of larger companies

Low Volatility
Lower volatility stocks tend to generate a higher risk- adjusted return than higher volatility stocks

Quality
Healthy companies tend to outperform less healthy companies

Momentum
Stocks with good recent performance tend to continue earning greater returns in the near term, compared with stocks with weak recent performance.

The Nature of Factors: Cyclicality

Why do factor returns tend to persist? Different factors have different underlying rationales (see below). On the one hand, Size and Value are risk factors that compensate investors for exposure to smaller companies that are perceived to be less stable, or to cheaper stocks that are perceived as distressed, so investors demand a premium to hold them. On the other hand, Momentum and Quality premia are primarily driven by behavioral biases of market participants, while returns in Low Volatility are primarily due to a market anomaly in which high-beta stocks tend to receive higher allocations.

Factors exhibit premia for different economic and behavioral rationale.

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Each factor is capable of outperforming the broad market over time, but performance can vary by economic environment. For example, Quality and Low Volatility tend to outperform during economic slowdowns or recessions. In contrast, Value, Size and Momentum have historically outperformed during economic booms.

As a result, the differences in cyclicality and theoretical underpinnings naturally lead to different risk/return characteristics for each factor.

Fortunately, not all factors outperform or underperform at the same time. Many factor premia have low correlations to each other.

To minimize the vagaries associated with each of the factors, investors can benefit from combining different factors to help provide diversification and reduce performance cyclicality. Additionally, diversifying across this array of factors can help reduce drawdown risk. In the face of muted return expectations and higher need for smoother returns, the low correlation across these factors over time can help preserve excess returns.

Disclaimer

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Investing involves risk including the risk of loss of principal.

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.

Equity securities may fluctuate in value in response to the activities of individual companies and general market and economic conditions.

Investments in issuers in different countries are often denominated in different currencies. Changes in the values of those currencies relative to the Portfolio’s base currency may have a positive or negative effect on the values of the Portfolio’s investments denominated in those currencies. The Portfolio may, but will not necessarily, invest in currency exchange contracts or other currency-related transactions (including derivatives transactions) to reduce exposure to different currencies. These contracts may reduce, take or eliminate some or all of the benefit that the Portfolio may experience from favorable currency fluctuations.

While diversification does not ensure a profit or guarantee against loss, investors in Smart Beta may diversify across a mix of factors to address cyclical changes in factor performance. However, factors may have high or increasing correlation to each other.

A Smart Beta strategy does not seek to replicate the performance of a specified cap-weighted index and as such may underperform such an index. The factors to which a Smart Beta strategy seeks to deliver exposure may themselves undergo cyclical performance. As such, a Smart Beta strategy may underperform the market or other Smart Beta strategies exposed to similar or other targeted factors. In fact, we believe that factor premia accrue over the long term (5-10 years), and investors must keep that long time horizon in mind when investing.

The stock/funds employs a value style of investing that emphasizes undervalued companies with characteristics for improved valuations, which may never improve and may actually have lower returns than other styles of investing or the overall stock market.

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.”

The stock/funds employs a momentum style of investing that emphasizes investing in securities that have had higher recent price performance compared to other securities, which is subject to the risk that these securities may be more volatile and can turn quickly and cause significant variation from other types of investments.

Low volatility stocks/funds can exhibit relative low volatility and excess returns compared to the Index over the long term; both portfolio investments and returns may differ from those of the Index. The fund may not experience lower volatility or provide returns in excess of the Index and may provide lower returns in periods of a rapidly rising market. Active stock selection may lead to added risk in exchange for the potential outperformance relative to the Index.

The views expressed in this material are the views of SSGA through the period ended March 31, 2018 and are subject to change based on market and other conditions. 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.

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