Consumption-based models predict that risk factors should be less profitable in bear markets than in bull markets; however, recent research shows that value (HML), profitability (RMW), investment (CMA), and momentum (UMD) factors are more profitable in bear markets than in bull markets. The size (SMB) and market (MKTRF) factors show the expected performance in bear markets. (See "Where is the risk in risk factors?".)
A risk factor may proxy for a consumption state and generate lower returns in a bad state. A lower return in a bad state requires a premium to be held. This research shows better returns in a bad state and low returns in a good state.
This strong behavior in bear markets has important implication for portfolio construction and asset allocation to factors. The poorer performance during the market recovery after the GFC is also given some better context. The long recovery was not good for factor risk versus market exposure.
The authors find that equity cash flow duration can explain this bear market behavior for the value, profitability, and investment factors and to a lesser extent momentum. Financial constraints can explain the profitability factor in bear markets. Constraints and duration are more important for those risk factors that seem to be more cash flow dependent.
Factor diversification can add value especially when the market turns bearish.
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