What has been going on with classic equity alternative risk
premia like size, value, and momentum? This has been a key investor question for the
last few years given their return underperformance. This return shortfall has caused some
investors to exit or avoid the equity ARP market and argue that it is not
working.
The researchers at Scientific Beta in their work “What Really Explains the Poor Performance of Factor Strategies Over the Last 3 Years?” conclude that the performance is unusual but perhaps not extraordinary. They find that other factors within the equity space have performed well and that some of the current underperformance is associated with macro factors. Additionally, we conclude that active involvement in the ARP space requires a broader diversification view of alternatives across all asset classes and intra-market factor strategies.
The researchers at Scientific Beta in their work “What Really Explains the Poor Performance of Factor Strategies Over the Last 3 Years?” conclude that the performance is unusual but perhaps not extraordinary. They find that other factors within the equity space have performed well and that some of the current underperformance is associated with macro factors. Additionally, we conclude that active involvement in the ARP space requires a broader diversification view of alternatives across all asset classes and intra-market factor strategies.
How bad has been the return performance for long/short size,
value, and momentum factor strategies? The numbers show that the returns are in
the bottom tail. This has not the worst period, but it should be a concern. However,
the chance of having a negative three-year period for these ARPs is about one
in three. On the other hand, low volatility, profitability, and investment ARP portfolios
have performed well. This has been a poor period for some strategy factors, but
not for all. The likelihood that multiple factor strategies all turn negative is rare.
It seems that before we announce the death of some factor strategies there should be some empirical context for their performance. All of these risk premia are time varying. There is no alternative risk premia that will generate positive returns in all market environments. They will be sensitive to the business cycle, interest rates, and other macro factors.
The macro factors suggest that there are some valid reasons for the underperformance based on the macro trend of turning from a good to bad economic environment. These macro links suggest that an improvement in the macro environment will likely see an improvement in these key equity factors. Value and momentum are both sensitive to the macro outlook spread.
Similarly, some risk premia are very sensitive to macro factors. For example, value and momentum are both sensitive to the term spread, albeit in opposite directions.
The macro factors suggest that there are some valid reasons for the underperformance based on the macro trend of turning from a good to bad economic environment. These macro links suggest that an improvement in the macro environment will likely see an improvement in these key equity factors. Value and momentum are both sensitive to the macro outlook spread.
Similarly, some risk premia are very sensitive to macro factors. For example, value and momentum are both sensitive to the term spread, albeit in opposite directions.
This paper does not try and explain away the poor performance of some equity ARP. It has not been good; however, the underperformance is partially tied to the macro environment. There has been some positive return movement into value over the last three months, so there may be slow switch to value ahead. The long-term performance and change in the macro environment may suggest that there are current opportunities in holding some underperforming ARP factor strategies.
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