What drives the performance of equity multifactor funds? While the value, quality, low risk and momentum factor styles have outperformed over the long term, there have been periods of underperformance. These include the tech bubble of the late 1990s, the Great Financial Crisis of 2008, and now the COVID-19 crisis. Value factor underperformance explains this latest drawdown.
While multi-factor equity funds generally had poor returns in the last couple of years, our strategies held up well until late 2019, but also lagged in 2020. In a series of three articles that accompany our paper “Equity factor investing: Historical perspective of recent performance”, we will look at the three possible sources of underperformance and ask: how have the value, quality, low risk and momentum factors performed recently and how does this compare with their long-term performance?
In a second article, we look at the impact of different choices for factors and risk controls. A third article will at the impact of portfolio constraints on performance.
Exhibit 1 shows the cumulated performance of the four factor styles. We used a universe of stocks similar to that of the MSCI World, S&P500 and MSCI Europe indices. Each style is a simple combination of some of the most commonly used factors for that style, i.e., the methodology is the same as that we use in our live strategies.
The results come from simulations of the performance of monthly rebalanced long-short portfolios constructed from the factors, as is usually done in academic studies. The portfolios have no macro-sector exposures and no beta exposures, again as in our live strategies. The volatility of the portfolios was set to target 2.5% at each monthly rebalancing. The more positive the performance, the better the factors predicted which stocks outperformed peers in each macro-sector.
All factors generated positive returns in the long term, i.e. cheap stocks (value), stocks of the most profitable companies (quality), less risky stocks (low risk) and stocks that have been outperforming (momentum) have on average outperformed other stocks over the long run.
Quality factors did better, both over the long term and recently, while momentum factors did better only recently. Low-volatility factors did well recently in Europe, but not in the US or globally. Value factors did well in the long term, at least in Europe and globally, but have disappointed since mid-2018. Finally, overall, factors did less well in the US than globally or in Europe.
Exhibit 1: Annualised excess monthly returns, volatility and information ratios of unconstrained long-short value, quality, low volatility and momentum factor portfolios; rebalanced monthly, beta-neutral, macro-sector neutral and targeting 2.5% ex-ante volatility for World and US indices in USD and Europe in EUR. No transaction costs; 31 July 1995 through 31 August 2020
Source: Bloomberg, FactSet, Worldscope, IBES, Exshare-ICE, BNP Paribas Asset Management. For illustration purposes only.
Each factor style has gone through occasional difficult periods, looking at drawdowns in performance of the same factor long-short portfolio strategies as in exhibit 1. A drawdown forms once the strategy reaches a peak in cumulated performance and starts losing from then on. The drawdown closes once the losses have been fully recovered.
The run-up to the tech bubble in 1998-99 and the Great Financial Crisis of 2008-09 were the toughest periods since 1995. Factors struggled in all three regions during the tech bubble, except for quality in the US. Many investors then wondered about the ability of factors to generate returns. During the global financial crisis, in particular when markets bottomed in 2009, there was another rough patch.
2020 was different as the poor performance was driven mainly by value. This factor underperformed sharply, even by historical standards, as the COVID-19 crisis and the impact of lockdowns imposed around the world sent markets into disarray.
In 2020, quality and momentum held up rather well. However, the COVID crisis resulted in historically extreme levels of underperformance. Since many quantitative portfolio managers rely more on value stocks, and this factor did poorly, we can identify the reasons for the lagging performance of factor investing.
In the next article, we will see that the results presented above are likely to have been a best-case scenario. Finally, in discussing the impact of typical portfolio constraints on recent performance, it becomes clear that, unfortunately, a long-only constraint is likely to have pushed last year’s performance further into negative territory.
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Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. The views expressed in this podcast do not in any way constitute investment advice.
The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.
Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).
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