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
Source: Bloomberg Finance L.P. as of 9/8/2020, based on the returns of the MSCI USA Quality Index, MSCI USA Value Weighted Index, MSCI USA Equal Weighted Index, MSCI USA Momentum Index, MSCI USA Minimum Volatility Index, and MSCI USA Index. Index returns are unmanaged and do not assume any fees. All dividends were reinvested. Past performance is not a guarantee of future results.
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:
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.
Source: Bloomberg Finance L.P. as of 9/8/2020 based on the holdings and returns of the MSCI USA Quality Index, MSCI USA Value Weighted Index, MSCI USA Equal Weighted Index, MSCI USA Momentum Index, MSCI USA Minimum Volatility Index, and MSCI USA Index. Past performance is not a guarantee of future results.
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.
Source: Bloomberg Finance L.P. as of 9/8/2020, based on the holdings and returns of the MSCI USA Value Weighted Index and MSCI USA Index. Past performance is not a guarantee of future results.
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.
Source: Bloomberg Finance L.P. as of 9/8/2020 based on the holdings and returns of the MSCI USA Value Weighted Index and MSCI USA Enhanced Value Index, the MSCI USA Quality Index and the MSCI USA Quality Sector Neutral Index, the MSCI USA Risk Weighted Index and the MSCI USA Minimum Volatility Index. Past performance is not a guarantee of future results.
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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1 Based on the rolling six-month returns of the five factors (Quality, Value, Size, Momentum, and Minimum Volatility) from 12/31/1998 to 9/8/2020 using the index returns for MSCI USA Quality Index, MSCI USA Value Weighted Index, MSCI USA Equal Weighted Index, MSCI USA Momentum Index, and MSCI USA Minimum Volatility Index
2 Based on the rolling six-month returns of the eleven S&P 500 Index GICS Sectors from 12/31/1998 to 9/8/2020
3 Based on the 2020 returns of 54 US-listed US Large Cap and Broad Market multifactor ETFs compared to the return of the MSCI USA Index as of 9/8/2020, per Bloomberg Finance L.P. data
4 S&P 500 Pure Value Index versus S&P 500 Index as of 9/4/2020
5 Bloomberg Finance L.P. as of 9/9/2020, based on SPDR Americas Research calculations
6 “No Pain, No Premium”, Corey Hoffstein, 2/4/2019, https://blog.thinknewfound.com/2019/02/no-pain-no-premium/
7 Fama-French data goes back to 1926
MSCI USA Enhanced Value Weighted Index
The MSCI USA Enhanced Value Weighted Index captures large and mid-cap representation across the US equity markets exhibiting overall value style characteristics. The index is designed to represent the performance of securities that exhibit higher value characteristics relative to their peers within the corresponding GICS® sector.
MSCI USA Equal Weighted Index
The MSCI USA Equal Weighted Index represents an alternative weighting scheme to its market cap weighted parent index, the MSCI USA
Index. At each quarterly rebalance date, all index constituents are weighted equally, effectively removing the influence of each constituent’s current price (high or low).
MSCI USA Index
The MSCI USA Index is designed to measure the performance of the large and mid cap segments of the US market.
MSCI USA Minimum Volatility Index
The MSCI USA Minimum Volatility (USD) Index aims to reflect the performance characteristics of a minimum variance strategy applied
to the MSCI large and mid-cap equity universe. The index is calculated by optimizing the MSCI USA Index, its parent index, for the lowest absolute risk (within a given set of constraints). Historically, the index has shown lower beta and volatility characteristics relative to the MSCI World Index.
MSCI Momentum Index
The MSCI Momentum Index is designed to reflect the performance of an equity momentum strategy by emphasizing stocks with high price momentum, while maintaining reasonably high trading liquidity, investment capacity and moderate index turnover.
MSCI Quality Index
The MSCI Quality Index aims to capture the performance of 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.
MSCI USA Quality Sector Neutral Index
The MSCI Sector Neutral Quality Index aims to reflect the performance of securities that exhibit stronger quality characteristics relative to their peers within the same sector.
MSCI USA Risk Weighted Index
The MSCI USA Risk Weighted Index is based on a traditional market cap weighted parent index, the MSCI USA Index, which includes US large and mid cap stocks. Constructed using a simple, but effective and transparent process, the MSCI USA Risk Weighted Index reweights each security of the parent index so that stocks with lower risk are given higher index weights.
MSCI USA Value Weighted Index
The MSCI USA Value Weighted Index is based on a traditional market cap weighted parent index, the MSCI USA Index, which includes US large and mid cap stocks. The MSCI USA Value Weighted Index reweights each security of the parent index to emphasize stocks with lower valuations. Index weights are determined using fundamental accounting data—sales, book value, earnings and cash earnings—rather than market prices.
S&P 500 Index
A popular benchmark for US large-cap equities that includes 500 companies from leading industries and captures approximately 80% coverage of available market capitalization.
S&P 500 Pure Value Index
The S&P 500® Pure Value index is a style-concentrated index designed to track the performance of stocks that exhibit the strongest value characteristics by using a style-attractiveness-weighting scheme.
The views expressed in this material are the views of SPDR Americas Research Team 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.
The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor.
All material has been obtained from sources believed to be reliable. There is no representation or warranty as to the accuracy of the information and State Street shall have no liability for decisions based on such information.
All the index performance results referred to are provided exclusively for comparison purposes only. It should not be assumed that they represent the performance of any particular investment.
Passively managed funds hold a range of securities that, in the aggregate, approximates the full Index in terms of key risk factors and other characteristics. Passively managed funds invest by sampling the index, holding a range of securities that, in the aggregate, approximates the full Index in terms of key risk factors and other characteristics. This may cause the fund to experience tracking errors relative to performance of the index.
Actively managed funds do not seek to replicate the performance of a specified index. The strategy is actively managed and may underperform its benchmarks. An investment in the strategy is not appropriate for all investors and is not intended to be a complete investment program. Investing in the strategy involves risks, including the risk that investors may receive little or no return on the investment or that investors may lose part or even all of the investment.
Equity securities may fluctuate in value in response to the activities of individual companies and general market and economic conditions.
Volatility management techniques may result in periods of loss and underperformance may limit the Fund's ability to participate in rising markets and may increase transaction costs.
A momentum style of investing emphasizes 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.
Investments in small-sized companies may involve greater risks than in those of larger, better known companies.
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.
Value stocks can perform differently from the market as a whole. They can remain undervalued by the market for long periods of time.
Because of their narrow focus, sector funds tend to be more volatile.