Factor Views 3Q 2020
Themes from the quarterly Quantitative Beta Research Summit
- Factor performance was mixed, on balance, with some factors recovering from losses in the first quarter while others continued along their recent trajectories.
- Equity factor volatility remained high: Size experienced its best quarter since 2009 while value suffered its second-worst quarter in 30 years (exceeded only by losses in Q1).
- Merger arbitrage bounced back over the quarter; however, other event-driven factors were broadly negative.
- Macro factors declined as historically sharp market reversals upended both time-series momentum and relative value momentum positioning across asset classes.
- We continue to see the outlook for equity value as attractive; additionally, we have upgraded our view for equity quality because of the emergence of the most compelling valuation spread since the dot-com bubble.
Following one of the most precipitous declines in the past century, risk assets recorded their best quarter since 1998. The extreme pivot was driven by unprecedented fiscal and monetary stimulus and improving sentiment (at least, over much of the quarter) about the path of economic recovery from the COVID-19 pandemic. Global equities were up 20%, credit spreads tightened, and oil prices nearly doubled as markets looked through a plunge in economic data at the beginning of the quarter and a record number of earnings guidance suspensions. Against this backdrop, the factors that we favor were mixed. Certain factors bounced back after suffering during Q1: Equity size experienced its best quarter since 2009, and merger arbitrage and FX carry both ended the quarter positive. Other factors continued their previous trajectories: Equity momentum was up yet again, while equity value extended its drawdown as investors’ preference for growth remained unshaken (Exhibit 1).
Factors were mixed in Q2, though they remain down, in aggregate, over the past year
Exhibit 1: Quantitative beta strategies long/short factor returns
While the outlook for COVD-19 remains extremely uncertain and a pickup in U.S.-China geopolitical tension reintroduced that risk to markets, we see the outlook for factors as attractive across a range of areas. Equity factors in aggregate, for example, are at the cheapest levels since the dot-com bubble, due to tailwinds behind value and quality. We expect factors should resume their role as diversifying sources of returns when markets and economic expectations normalize.
Factors in focus
Equity factors: Opportunity for the quality factor continues to improve
Performance was mixed over the quarter across equity factors and geographies. One constant was the underperformance of value, which in May experienced its second-worst month in about 30 years (exceeded only by losses right before the dotcom bubble peak in March 2000) and its second-worst quarter (exceeded only by Q1).1 Size, on the other hand, recovered sharply from Q1 losses to enjoy its best quarter since 2009 as fears of liquidity risk and distress risk faded (at least temporarily). Momentum was up on a global basis and positive in most markets; however, it was flat in the U.S. as market leadership shifted in April from high quality to low quality names.
This reversal also impacted the quality factor in the U.S., which posted negative returns and continued to lag other regions (Exhibit 2). The quality factor continued to underperform in the small cap segment of the market—particularly in the U.S. (Exhibit 3), where investors have tended to favor either mega cap names presumed to be secular growers or low quality small cap stocks that received a lifeline from government stimulus. We view the spread of underperformance from value to quality as a signal of sentiment’s dominance over fundamentals; it is also a sign of investor preferences that we expect will meanrevert over time.
Quality has underperformed in the U.S., in particular across smaller cap stocks
Exhibit 2: Quality factor performance Exhibit 3: U.S. quality factor by region performance by market cap
The quality factor (Exhibit 4) has been on our radar in recent quarters and has become increasingly attractive.2 The difference in fundamentals between high quality and low quality companies (e.g., profitability or financial risk metrics) has continued to grow; however, the market is no longer rewarding high quality companies’ valuations to the degree that it once was. In fact, a dislocation has recently emerged: High quality companies are now historically cheap relative to their low quality counterparts at the same time that they are exhibiting relatively strong fundamentals. This scenario is rare. However, the last two times it occurred—during the dot-com bubble peak in March 2000 and following the global financial crisis dash-to-trash rally in 2009— the quality factor went on to outperform by 34.9% and 2.4%, respectively, highlighting the potential for tailwinds (although that is, of course, far from a guaranteed outcome).
The quality factor has become increasingly attractive
Exhibit 4: Quality factor valuation spread (global)
Event-driven factors mixed over the quarter
Following an extremely challenging March, event-driven factors were mixed over the quarter. The merger arbitrage factor was up and is once again positive over the past year; it benefited from the attractive spread levels we noted in our Q2 Factor Views and suffered relatively few deal failures due to COVID-19. However, other event-driven factors—such as share buybacks, spinoffs and activist factors—continued to languish in a drawdown that has accelerated over the past 14 months.
We maintain a positive outlook for the merger arbitrage factor, where we still consider spreads (the difference between the stock price of a company targeted for acquisition and the announced acquisition price) to be attractive. We have a more tempered view on other event-driven factors, though, given that we expect a decline in corporate activity levels, which would limit the ability to capture these factors while also remaining diversified.
Macro factors suffer from sharp reversals across asset classes
Momentum factors experienced a challenging quarter as historically sharp reversals upended positioning across asset classes. Heading into the quarter, time-series momentum signals were biased negative across equity and commodity markets. Relative value momentum signals were bearish on energy commodities and commodity-linked currencies (e.g., AUD and NOK) compared with precious metals, agricultural commodities and safe haven currencies (e.g., USD and CHF). Of course, this positioning proved to be painful over the subsequent months. Carry factors, on the other hand, were positive in aggregate. In particular, they were led by gains from FX carry, which rebounded after a difficult Q1 (providing valuable diversification benefits when paired with FX momentum).
Carry spreads are generally below long-term averages, particularly across G10 government bonds and FX markets. This suggests a diminished potential to capture carry in those markets. Among momentum factors, dispersion in price moves was average across currencies and commodities. The number of significantly trending assets was somewhat neutral in aggregate, as short-term (e.g., three-month) and longer-term (e.g., 12-month) signals conflicted across a number of markets.
Factor performance remained a bit choppy over the quarter, with certain factors bouncing back after a weak Q1 while others continued along increasingly well-worn paths. The potential across equity factors looks particularly strong; however, as always, we believe in diversifying across a broad range of compensated factors while minimizing exposure to uncompensated risks.
Factor Opportunity Set
The table below summarizes our outlook for each of the factors accessed by the Quantitative Beta Solutions platform. It does not constitute a recommendation but, rather, indicates our estimate of the attractiveness of factors in the current market environment.
Factor Views Vs. Last quarter:
- Equity momentum: Long/short global developed stocks, based on price change and earnings revisions; sector and region neutral
- Equity quality: Long/short global developed stocks based on financial risk, profitability and earnings quality; sector and region neutral
- Equity size: long/short global developed stocks based on market capitalization; sector and region neutral
- Equity value: Long/short global developed stocks based on book-to-price, earnings yield, dividend yield, cash flow yield; sector and region neutral
- Merger arb: Long target company and short acquirer (when offer involves stock component) in announced merger deals across global developed markets
- Event-driven (other): Conglomerate discount arbitrage, share repurchases, equity index arbitrage, post-reorganization equities and shareholder activism
- Macro carry: FX G10 carry, FX emerging market carry, fixed income term premium, fixed income real yield, commodity carry
- Macro momentum: FX cross-sectional momentum, commodity cross-sectional momentum and time-series momentum across equity, fixed income and commodity markets