Given the extreme market volatility and disruptions to the economy caused by the spread of the COVID-19 pandemic, asset managers using factor-based investment strategies have seen their risk exposures shift in unexpected ways.
At the same time, factor investing has grown as an approach to screening stocks based on the attributes that drive risk and returns. Factor-based strategies including factor ETFs can be used to complement traditional index or active investments in a portfolio.
Asset managers and hedge funds often use economic factors such as earnings yield and liquidity, or style factors such as value, size, profitability, quality, and momentum to construct portfolios and manage risk exposures.
“Amid growing concern over the spread of coronavirus, quants had seen unpredictable behaviour in factor-based investment strategies during (late February’s) plunge in stock prices, in some cases cancelling out diversification benefits,” wrote
Risk.Net on March 5.
Global index companies that develop factor models updated their clients on factor risk exposures and returns.
“As the response to the coronavirus evolves, we are witnessing rapidly changing risk profiles across global markets,” said Melissa Brown, Managing Director and Head of Applied Research at Qontigo, during a webinar on March 25.
“We’ve seen a substantial jump in top line and benchmark risk. And it hasn’t just been market risk, all of the components of our risk models saw an increase,” said Melissa Brown, managing director and head of applied Research at Qontigo during a webinar
“Managing Your Portfolio in an Extreme US Factor Environment.” “You can see that industry risk went up, stock specific risk went up, and style risk went up,” said Brown.
Concerns over the COVID-19 pandemic rattled global equity markets during the first quarter of 2020, wrote MSCI’s researchers. Global equities declined 21.3% during Q1, rebounding 15.4% from the low on March 23, based on MSCI’s AWCI Index, a broad global
index measuring the performance of stocks around the world.
Factors were also impacted by other data points and events, according to MSCI’s blog. In an April 2 blog post titled “Factors in Focus: Risk sentiment and factor dynamics in a crisis.” MSCI researchers cite the turmoil in the energy markets and a spike
in the CBOE Volatility Index (VIX), a key volatility metric.
In volatile markets, managers were monitoring portfolios in real-time to determine how factors were behaving and affecting risks in their portfolios.
Real-Time Risk Analytics
For example, Woodline Partners LP, a market-neutral hedge fund manager, partnered with FlexTrade Systems to integrate the MSCI Barra risk factor model into the FlexONE order and execution management system.
“We’re able to look at our portfolio exposures to a number of these types of factors on a real-time basis,” said Roshan Raman, Head of Quantitative Research at Woodline.
Portfolio managers are able to view the data from MSCI through the OMS side of the OEMS, which empowers them with real time pro forma risk at the point of order entry.
In such an unpredictable market, the integration of risk analysis tools into the OEMS has proved to be effective in helping portfolio managers test out assumptions before committing to an execution.
“We continue to see a heavy reliance on factor analysis upstream in the order life cycle, at the time of portfolio construction that reflects the entire real-time state of the portfolio. What used to be an end-of-day process, is now provided by an OEMS in
real-time taking into account fills and pro forma order data,” said Aaron Levine, Vice President, OEMS Solutions at FlexTrade.
Demand for the integration of factor-analysis risk tools has gone through an evolution. “On average investment firms are analyzing their factor risk more frequently and more firms are doing it,” said Brown of Qontigo. “Ten or 15 years ago, some firms had
a chief risk officer or someone looking at the risk, but it wasn’t really common,” said Brown. “I think particularly after the global financial crisis that got bigger because you wanted to make sure you didn’t have some outstanding huge risk bets,” said Brown.
Some firms may have moved to exception reporting where every day the chief risk officer provides each portfolio manager with a report spelling, “You violated your risk constraints here.”
In the last month and half, however, Brown said managers were probably looking at their portfolios every day vs. when markets were chugging along. “A lot of hedge funds are much more careful about looking at risk every day whether markets are extremely volatile
or not so volatile because they’re trying to stay market neutral,” said Brown.
Factor Returns in Q1
How did equity factors perform during the turbulence?
“Stocks with positive momentum, low volatility, strong balance sheets (low leverage, high profitability) and higher ESG exposure outperformed,” wrote MSCI reviewing factor performance to their parent indexes in Q1. “Low-beta [stocks] reversed from March
18, 2020, following unprecedented support by both fiscal and monetary stimulus,” stated MSCI in the blog.
By contrast, value and yield registered large underperformance in all regions.
On the webinar, Qontigo, examined how factors impacted rotations in industry and sector returns as well and shifts in correlations between the factors, pointing out how they could add to active risk in portfolios. Up until close to the end of February, the
correlations between profitability and other factors like leverage were close to zero. But that changed dramatically after the market hit its peak on Feb. 19 and fell apart.
For example, the correlations between profitability and specialty retail went down, while the correlations between pharmaceuticals and biotech went up, said Brown. “You don’t want things that are so highly correlated with each other, if you can avoid it;
you don’t want things that are so negatively correlated, that they cancel each other out,” said Brown in an interview.
As markets reacted to news about the COVID-19 pandemic, there were massive shifts in beta, a measure of risk to overall market sensitivity, said Omer Cedar, CEO Of Omega Point, provider of a portfolio risk and optimization platform, who spoke on the Qontigo
webinar. Beta is one of 13 style factors in Axioma’s US4 Fundamental Risk Model.
“We’re going to see sectors that transition from being traditionally high-beta stocks to become low-beta stocks,” said Cedar, adding, “There’s a flip here.” For example, biotechnology, a sector comprised of 25 stocks in Axioma’s model, saw the highest decreases
in beta, said Cedar. On the other hand, hotels, restaurants, travel, and leisure (i.e., cruise lines), along with insurance companies and healthcare providers had massive increases in beta over that time period. “Autos, hotels, and cruise lines have seen their
betas double,” said Cedar.
“The concern here is that when you ‘re looking at your portfolio, what was low beta a month ago, it is becoming high beta and essentially crossing into some of the higher beta sectors,” he said.
Despite the S&P 500’s bounce off March’s lows and
rallies during the first two weeks in April due to optimism over a vaccine in development and states lifting restrictions on business activity, U.S. markets have continued their volatile streak. With uncertainty over how long the novel coronavirus will
persist, experts remain cautious about the outlook for the rest of the year.
“Factor behaviors and risk profiles have whipsawed institutional portfolios in both down and up market data,” cautioned Brown on the webinar.
“We’re still expecting that volatility level to stay fairly high for a while,” said Brown in the interview. “Certainly, that’s what our models are predicting.”