Charting the Market: Examining 2020’s Not-So-Fun Factor Experience

It has been a rough year for factor-based strategies. Only two factors—Momentum and Quality—are outperforming the broader market so far in 2020, and many multifactor strategies are underperforming the traditional market cap weighted benchmarks for their respective regions.

Why is this happening and what does it mean for portfolios that have embraced factor investing? In this edition of Charting the Market, we explore a key reason behind the underperformance and illustrate how strategy construction decisions can alter performance differences among factors with the same name.

Factor returns at high dispersion but low breadth
We often examine dispersion and breadth when trying to characterize a given return environment. In 2020, factor dispersion is elevated relative to history (19% versus long-term median of 8%, based on rolling six-month periods)¹. Factor dispersion, however, is still low relative to sector dispersion (53% versus long-term median of 27% for rolling six-month returns).²  This is a reason why we favor sector rotation over styles/factors .

While dispersion is elevated, factor return breadth is low. Using the same rolling six-month return periods, the average number of factors underperforming the broader market in 2020 is 3.2, compared to a historical annual average of 2.2, as shown below. In fact, the 3.2 reading is the highest ever for a year. Such low breadth is one of the reasons why 91% of US-listed large-cap multifactor ETFs have underperformed the broad market in 2020, lagging by an average of 4.2%.³

Underweight the segment that has worked
If we examine which area of the market has done well in 2020, we can partly explain the low breadth in factor returns. So, what’s been working well this year? Mega-cap growth stocks. Factors, however, deviate from the traditional market cap weighted paradigm (i.e., weighting by something other than price) and therefore are highly likely to be underweight mega-cap stocks. Multifactor funds are also likely to be underweight growth as many strategies include value as a factor.

To prove the “low weight to mega-caps” theory, we looked at the top contributors to the broad market return. In 2020, five out of the top 10 securities by market cap in the MSCI USA Index also rank in the top 10 by return contribution. In fact, the top 10 securities by return contribution make up more than 100% of the overall market return—and this includes the tech sell-off which began in September. Next, we took:

• The top 10 contributors to the broad market’s 2020 year-to-date return 
• Calculated the average active weights (i.e., underweight or overweight) of those stocks in each of the specific factors for the year-to-date period.

Based on this analysis, we see the degree to which factors have been underweight those stocks. As shown below, in four out of the five factors, the cumulative average active weight in those 10 firms relative to the MSCI USA Index is negative (underweight). As a result of being underweight, the ensuing return from those 10 firms is below that of what the market earned for the same stocks (+10.8%). Momentum is the only factor overweight what has worked—which is sort of the point of the factor, at a very basic level—and therefore its return on those stocks is higher than the broad market’s return.

Factor strategy construction can play a critical role
Factor strategy construction can have a material impact on performance trends. For example, the Value factor has been particularly hit hard during the pandemic: On certain days, the factor’s rolling six-month return relative to the broader market has fallen into the 99th historical percentile. At one point, it was just 59 basis points away from the all-time worst six-month decline, a -14.15% figure posted during the dot-com era.

While the magnitude of Value’s market-relative performance is near all-time worst levels, the persistency of losses is far from records. As shown below, the number of consecutive days during which the rolling six-month relative return was negative currently stands at 168. The Value pessimist may say the pain could continue: 168 days is still 213 days less than the all-time record of 381 days, reached in 2016.

How you define Value matters in this context. Under the definition used above, Value is down 10% over the last six months and down 14% in 2020 relative to the broader market. A more concentrated Value exposure is down 31%⁴ and a sector neutral value exposure is down 23% in 2020 versus broad beta. This is not the only occurrence of a sector neutral factor exposure underperforming a non-sector neutral exposure this year. As shown below, both Quality and Value sector neutral exposures have underperformed a non-sector neutral version in 2020. However, a Minimum Volatility exposure with sector constraints has outperformed a risk weighted low volatility exposure with no sector controls in place. For Momentum, as we show in this month's full chart pack, a large driver of returns has been overweight exposure to certain Consumer Discretionary names.

Construction choices, such as factor descriptors (price-to-book versus price-to-earnings), sector constraints, and rebalancing can have significant impact on factor performance trends and should be acknowledged when making comparisons or utilizing factor based products. Our framework for classification and due diligence checklist were created to help address these issues.

Factors for the long haul
Investors have noticed the lackluster short-term performance of factors, as more than $11 billion has been redeemed from US-listed smart beta ETFs in 2020.⁵ Factor investing, however, shouldn’t be viewed through a short-term lens. The academic research that serves as the foundational underpinnings of factor investing was examined over decades. A similarly long timeframe of evaluation should also apply to investors implementing a factor-specific viewpoint. After all, short-term pain may be one reason why premiums exist (i.e., no pain, no premium).⁶

That is not to say we should ignore short-term gyrations, but rather, we should put short-term moves in the larger context of a factor’s performance; however, this raises another issue. Few of the factor strategies in ETF form have a long enough track record. Thus, the trust in a backtest. Further complicating the issue, many ETF factor construction methodologies are not the same as those found within the academic literature upon which the factor foundations were built (i.e., long/short versus long-only).

2020 has delivered a not-so-fun factor experience. But factor investing is a long-haul journey that seeks to capture a presumed premium. While there may not be a live track record that goes as far as back the Fama-French data,⁷ conviction can help. If your investment philosophy features conviction that premia exist, and you’re comfortable with how the factor exposure is constructed to capture said premia, then you may be better positioned to ride out this tumultuous year for factors.

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