Saturday, November 9, 2019

Factor-based investing across the business cycle - There are defined patterns

Key investment factors such as momentum, value, size, quality, and volatility are time-varying and related to changes in the business cycle. Compensation or a return premium is necessary to offset the risks to consumption during an economic slowdown. This is fundamental to the market beta risk premia as well as factors such as size. 

Holding other factors may mitigate some of the risk from holding the market portfolio, but business cycle risks will not be eliminated through factor diversification. Nevertheless, we have history to tell us what will be the returns from different factors conditional on different points in the business cycle. These conditional returns are presented in the short white paper, Factor-based equity strategies in the business cycle – some basic analyses by the researchers at Vontobel. 

In a recession, there is value with holding small cap, quality, and min volatility factor exposures and avoiding value and momentum. More specifically, if we are in a late expansion period, there should be a tilt to momentum and quality but the return profile will flip to other factors if we move to an early recession. 

The market seemed to focus on the minimum volatility factor when recession warnings increased only to see a rotation to other factors as recession fears have declined. The risks to investors increase when market expectations about a recession switch quickly as seen over the last few months. While timing is never easy, investors should be aware of the conditional returns across economic environments.   

No comments: