Carrying on Through a Crisis, with Factors

• Systematic strategy factors such as carry, value and momentum may be employed as tools by rates, corporate-credit, foreign-exchange and commodity investors to help navigate crises.
• We find that carry factors tended to have positive returns in the periods of declining volatility following a crisis and negative returns when volatility spiked, hallmarks of a short-volatility return profile.
• Tactical decisions in a crisis period can make a significant difference in long-term returns. When volatility is high, long-horizon investors have benefited from selling it.

Long-horizon investing means more than just holding a static allocation. Tactical decisions, particularly during crises, can have a significant long-term impact on portfolio returns. We wrote before about how de-risking at the nadir of the COVID-19 crisis may have hurt long-term returns for equity investors, as markets experienced the fastest V-shaped recovery in recent memory. While factors have long had a place in constructing equity portfolios, investors increasingly use factors in sovereign and corporate bonds, commodities and currencies. In this post, we ask: Which non-equity factors have been the best performers coming out of recent crises, and why?

We focus on three systematic strategy factors in each of the above asset classes from the MSCI Multi-Asset Class (MAC) Factor Model: value, carry and momentum. Each reflects a common driver of return: value, the return due to the reversion of temporary mispricing to fundamentals; carry, the return on high-income assets if the market is unchanged; and momentum, the tendency of medium-term returns to persist.¹ Ultimately the specific expressions of these factors in each asset class reflect classic investment themes, such as investing in downward-sloping futures curves in commodities or high-spread corporate bonds.

To identify which factors performed best in past crises, we looked at which ones experienced positive cumulative return six months after large equity-market drawdowns. We identified five such drawdowns — defined by an eight-week trailing loss exceeding 10% — occurring since mid-2008.² The exhibit below summarizes the results, showing the number of positive post-drawdown returns for each factor. Carry stands out as a common theme among the high-performing factors, while value’s and momentum’s results were more mixed.

Carry Tended to Bounce Back After Equity Drawdowns

Source: MSCI MAC Factor Model

In the next exhibit, we further illustrate the effect by juxtaposing the equity drawdown with the post-crisis carry-factor return. Credit, commodity and currency carry were the most consistent performers, while rates carry exhibited stronger performance in earlier periods. We also note that the correlation of the carry-strategy-factor return in each asset class with the global equity factor was generally positive and in all cases correlations spiked in March 2020 (data not shown).

Carry Performance Was Most Consistent in Credit and Commodities Through a Range of Equity Scenarios

Each plot corresponds to an equity-market drawdown. The equity return reflects the trailing eight-week global-equity-market return ending on the displayed date. The carry returns reflect the six-month total returns from the carry factors following the crisis period. Source: MSCI MAC Factor Model

Why Might Carry Have Done Well Coming Out of Crises?

One possibility is that the carry factor can behave like short-volatility strategies; i.e., it has tended to succeed while volatility is low or falling and tended to lose money when volatility spikes. Declining volatility, coming out of a crisis, could thus give carry a tailwind.

To illustrate this effect, in the exhibit below, we plot carry systematic strategy factors’ weekly six-month rolling total returns for credit, currency, commodities and rates against the rolling six-month change of the Cboe Volatility Index® (VIX) from mid-2008 through the end of 2020. The negative correlation between VIX changes and carry returns indicates that the strategy factors have tended to do well when VIX declined. But carry exposure has not been a free lunch; volatility can rise quickly and unexpectedly, harming volatility sellers.

Carry-Factor Returns Were Negatively Correlated with Volatility Changes

Points are weekly observations of trailing six-month changes in the VIX and the trailing six-month carry-factor total return in each asset class. A trend line and 95%-confidence interval slope envelope are also shown. Source: Cboe, MSCI MAC Factor Model

Factoring in Post-Crisis Behavior

This historical study illustrates that carry exposure tended to provide excess return following large equity-market drawdowns in the sample period, due, in part, to the resemblance of carry and short-volatility strategies. But portfolio and risk managers may wish to recognize carry’s embedded tail risk and keep an eye on their exposures.

¹The implementation of each strategy is asset-class-specific. For details of descriptor and factor construction, see: Shepard, P., DeMond, A., Xiao, L., Zhou, C., and Ahlport, J. 2018. “The MSCI Multi-Asset Class Factor Model.” MSCI Model Insight.

²The start dates for the factor return analysis were Nov. 28, 2008; March 6, 2009; Sept. 23, 2011; Feb. 12, 2016; and March 27, 2020.

Further Reading

The MSCI Multi-Asset Class Factor Model (client access only)

The Risk of Risk Limits

Has global sovereign rates momentum headed in reverse?