Factors in Focus: How Trendy Is Your Style Factor?

• After a sharp fall in global equities in March, the MSCI ACWI Index recovered in Q2, returning 19.4%, as lockdown restrictions eased throughout the world. MSCI World outperformed MSCI EM, and MSCI USA outperformed within developed markets.
• MSCI Quality and Momentum equity factor indexes continued to outperform in Q2, while excess returns in MSCI Carry, Value and Low Size Corporate Bond Factor Indexes outperformed the parent IG USD Corporate Bond Index.
• The MSCI Adaptive Multi-factor Momentum Index outperformed the broad market YTD through May 29, and over the last 10 years. As of June 30, the adaptive multi-factor model was overweight low size and value.

Global equities recovered from their lows in Q2 2020, as investors rushed back into risk assets on the gradual reopening of economies worldwide. Markets, overall, pushed aside any pandemic-induced fears and instead focused on businesses getting back on track — aided by the stimulus offered by central banks and governments across the globe. The MSCI ACWI Index was up 19.4% for the second quarter, ~10% away from its all-time high of February 2020.

As markets rallied worldwide, investors took on high-beta exposure and rotated away from stocks with lower risk. Stocks with high turnover relative to their market capitalization fared well, which led to a strong performance of the liquidity factor. ESG, profitability and momentum added to gains seen in Q1 2020.

Factor Performance in Q2 2020

Factor performance of MSCI Global Equity Model (GEM+ESG) pure factors from March 31, 2020, to June 30, 2020.

All regions saw a sharp recovery in the quarter, though recovery was more pronounced in mid- and small-cap stocks in the developed markets. Asian small caps were first to recover during Q1, and in Q2 non-Asian small caps followed suit. Smaller companies have historically outperformed larger ones in recovery environments and, thus, low size was one of the selected factors in a recovery environment in the Macro pillar of our Adaptive Multi-Factor Framework (see “MSCI’s Adaptive Multi-Factor Allocation Model Headed into Q3” section later in this post).

High Volatility Led Across All Regions

The table shows regional variations of the MSCI Minimum Volatility Index (USD), MSCI High Dividend Yield Index, MSCI Quality Index, MSCI Momentum Index, MSCI Enhanced Value Index, MSCI Equal Weighted Index, MSCI USD IG Low Risk Corporate Bond (under Low volatility), MSCI USD IG Carry Corporate Bond (under Yield), MSCI USD IG Quality Corporate Bond, MSCI USD IG Value Corporate Bond and MSCI USD IG Low Size Corporate Bond, from March 31, 2020, to June 30, 2020.

Low volatility was one of the worst-hit factors during this time, as investors changed their positioning from defensive low-volatility stocks into higher beta stocks, perhaps partly in anticipation of an economic recovery. The dividend-yield factor was also a weak performer, as many companies cut or cancelled their dividends. However, as noted in a previous blog, quality screens such as those in the MSCI High Dividend Yield Index would have somewhat cushioned an even larger negative impact.

Most recently, we have seen an inflection in some factor performance. After beating the benchmark for eight straight months, quality took a break and underperformed in June. Low size reversed as well, outperforming in June.

Low Size and Quality Took a U-Turn in June, While Momentum Extended Gains

The table shows active return (%) performance of the MSCI ACWI Minimum Volatility Index (USD), MSCI ACWI High Dividend Yield Index, MSCI ACWI Quality Index, MSCI ACWI Momentum Index, MSCI ACWI Enhanced Value Index and MSCI ACWI Equal Weighted Index for Q2, April, May and June 2020.

Continuing to Track the Value and Momentum Story

After the strong recovery in markets, where does that leave valuations? Having fallen below their historical median in March, valuations of many of the benchmark regional indexes were at their all-time high at the end of June. The chart below shows their forward P/E percentile with respect to their own cumulative history. This shows that the market recovery has been quick and sharp as compared to the expectations of forward earnings. The forward P/E for MSCI ACWI was 19.18 at the end Q2 2020, up from 13.39 at the end of Q1.

Valuations were Elevated in a Historical Context for ACWI, Europe and World Indexes

The chart shows the percentile of forward P/E ratio with respect to its own cumulative history (from June 30, 2003, to June 29, 2020) of the MSCI AC Asia ex Japan, MSCI ACWI, MSCI Emerging markets, MSCI Europe, MSCI Japan, MSCI USA and MSCI World indexes. For a clearer picture, only the last 10 years of data is plotted.

Momentum has had a strong run over the last few years, and, despite the sudden market shocks and bouts of volatility, was a leading factor index in Q1 and for most of Q2. The chart below plots the MSCI ACWI Momentum Index’s active returns anchored around five previous major market bottoms, as well as the most recent. Based on the average of the previous five market bottoms, momentum underperformed, as it has historically during market inflection points. But, surprisingly, as the market turned from the March 23 low, momentum continued to perform well. It was only in June, when low size reversed, that momentum experienced a notable drawdown. However, it was quick to recover and was again up 5% by the end of quarter.

Momentum Performance Anchored Around Market Bottoms

The chart shows the cumulative active returns of the MSCI ACWI Momentum Index from 42 days before to 71 days after the major market bottoms of March 23, 2020, and the average of Dec. 25, 2018, Feb. 11, 2016, Oct. 3, 2011, March 9, 2009 and March 12, 2003, anchored around the market bottom.

Credit Factors’ Performance Reversed in Q2

As fears of the pandemic started to subside and economies across the globe started reopening, the MSCI USD IG Corporate Bond Index exhibited strong returns of 7.1% in excess of the duration-matched Treasury returns over Q2 2020. The performance was fueled, in part, by the Federal Reserve’s commitment to follow through on the previously announced measures to purchase investment-grade corporate bonds and provide liquidity to the market. The option-adjusted spread (OAS) of the index continued to ease throughout the quarter, after peaking in March. It landed at 163 basis points (bps) on June 30, still higher than the 107 bps level at the start of the year.

The performance of credit style factors in Q2 reversed the trends of Q1. Carry, defined by bonds with relatively high OAS, experienced the largest turnaround and outperformed the parent index by 7.3%, on an excess-returns basis. The value and low size factors also outperformed by 1.4% and 2.9%, respectively. Defensive factors characterized by issuers with shorter durations and stronger credit ratings fared less well in the recovery — the low risk factor underperformed by 3.7% and the quality factor underperformed by 3.1%.

Carry Factor Had Largest Turnaround in Q2

Active excess returns of the MSCI USD investment-grade corporate-bond factor indexes relative to the parent index for Q2, April, May and June 2020, before including any transaction-related costs. Excess returns computed by subtracting the duration-matched Treasury returns from the total returns of the index over the corresponding period.

A Look Across Sectors

Technology continued its move upwards in Q2, while financials continued its move downwards from the last quarter. Both the quality and momentum factors have been supported by these two sectors, with their over- and underweight positioning in them, respectively. Consumer discretionary stocks were also strong performers as an increase in economic activity was expected to generate discretionary spending, which had cooled in the lockdown.

Technology Continued to Outperform, While Financials Continued to Underperform

Active returns of MSCI sector indexes vs. the MSCI ACWI Index for Q2 2020.

Factor Momentum was Real

As we’ve detailed previously, factor momentum has been shown to persistently outperform the market in various studies. Over the last three years, quality and momentum factor indexes were among the top three performers in the majority of the quarters from Q3 2017 through Q2 2020.

Table shows the top three performing factor indexes in the given quarters.

Our Adaptive Multi-Factor Framework (AMF)¹ incorporates a factor allocation strategy designed to exploit the persistence in factor returns. The Momentum pillar in the MSCI AMF Index overweights the top three performing factors and underweights the bottom three factors relative to an equally weighted factor mix, at every quarterly rebalancing. This has been the top-performing pillar overall, beating the benchmark as well as the equal-weighted combination of all four pillars in the AMF.

Relative Performance of the AMF Momentum Pillar

Chart shows the relative performance of the MSCI World Adaptive Multi-factor Index and MSCI World Adaptive Multi-factor Momentum Index with respect to the MSCI World Index from Nov. 26, 2008, to May 29, 2020.

MSCI’s Adaptive Multi-Factor Allocation Model Headed into Q3

Our adaptive multi-factor framework is a model designed to analyze decisions about tilting toward factors. Our research has shown that factors were sensitive to changing market conditions and suggests there is value in taking a holistic approach to factor assessment that encompasses the macro environment, valuations, recent performance trends and risk sentiment.

As of June 30, 2020, our adaptive multi-factor model showed the following exposures across the four pillars:

• The macro cycle pillar indicated a contraction and thus overweighted value, low volatility and quality, based on the Chicago Fed National Activity Index, Federal Reserve Bank of Philadelphia’s ADS Index and the PMI.
• The valuation pillar overweighted value, low size and yield, based on the valuation gap compared to an equal-weighted factor mix in the context of nearly 30 years of a factor’s history.
• The momentum pillar selected momentum, quality and low size, based on the last three months’ relative performance.
• The market sentiment pillar showed a risk-on environment based on VIX term structure and neutral environment based on credit spreads, resulting in overall mild overweight to momentum, value and low size.

Exposures from MSCI’s Adaptive Multi-Factor Allocation Model

As of June 30, 2020. Positive exposures are denoted as + or ++, negative as - or --, neutral as N.

Overall, our adaptive multi-factor model showed a mild overweight to low size and value and a mild underweight to yield and low volatility, with momentum and quality being neutral.

¹Varsani, H. and Jain, V. 2018. “Adaptive multi-factor allocation.” MSCI Research Insight.

Further Reading

Factor Trends in Q2 2020: Factors in Focus

Factors — Elements of Performance

Factor Trends: What’s in? What’s out? Podcast

Current Market Implications — Q3 Webinar

Factors in Focus: Risk Sentiment and Factor Dynamics in a Crisis

Factors in Focus: Will 2020 Vision Sharpen Exposures?

Adaptive Multi-factor Allocation