Author Details

Abhishek Gupta

Abhishek Gupta
Executive Director, MSCI Research

Ashish Lodh

Ashish Lodh
Vice President, MSCI Research

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Factor Investing Held in High-Volatility/-Concentration Period

  • The U.S. equity market has experienced increased market volatility and higher concentration over the last three years.
  • Even as volatility has risen, MSCI single-factor indexes have delivered high factor exposures. While factor indexes had higher total absolute and active risk, factors continued to play a key role in driving risk, and stock-specific risks did not dominate.
  • MSCI single-factor indexes had large underweights to the top-10 U.S. and global developed-markets-ex-U.S. stocks, which had a negative return impact. But only a small portion of performance was driven by stock-specific effects.

U.S. equity markets experienced increased volatility over the last few years. Simultaneously, a handful of megacap companies increased their market-cap share in U.S. equity markets, exposing investors to concentration-related risks. Has this hampered investors’ ability to capture factors effectively? Have stock-specific1 risks dominated factor indexes? We found in our analysis that MSCI factor indexes remained robust and factors still played a key role in explaining risk.


Rising Market Volatility and Concentration

We begin by contrasting volatility and concentration from 2018 to 2020 compared to 2015 to 2017. Based on the Cboe VIX® index, average volatility over the more recent three years was 6 volatility points higher than in the previous three-year period. In addition, in the last three years the MSCI USA Index experienced a total of 72 trading days with market swings exceeding 1.5%, compared to 18 in the prior three-year period.

Concentration in U.S equity markets also rose since 2018, with the effective number (EN) of securities falling to 70 in August 2020.2 Global developed-markets-ex-U.S. equities (represented by the MSCI World ex USA Index) also showed signs of increasing concentration over the last three years. We take this change in volatility and concentration regimes to examine robustness in the MSCI USA and MSCI World ex USA Factor Indexes in the high-volatility and -concentration period (2018 to 2020) relative to the low-volatility and -concentration period (2015 to 2017).


Higher Volatility Had Minimal Impact on Factor-Index Exposures


Equity-Market Volatility and Concentration Over Time

Higher market volatility can make a company’s factor exposures more dynamic. This is particularly true for factors that have a price element built in. For instance, with larger price swings, a security’s price momentum (expressed using recent past returns) or price-to-earnings ratio can change quickly, impacting its momentum and value exposures, respectively. At a factor-index level, however, exposures can potentially be more persistent, as security-level changes offset each other and/or as indexes rebalance to reflect stocks’ changing target-factor exposures. In fact, we observed that the MSCI Factor Indexes exhibited similar levels of active factor exposure over the recent, high-volatility and -concentration period compared to the prior three-year, low-volatility and -concentration period across both U.S. and developed-ex-U.S. markets.


Active Exposures of Factor Indexes to Their Target Factors

Next, we explore the impact of rising market volatility on the total absolute and active risk (i.e., volatility of excess returns) of factor indexes. Higher levels of market volatility meant that over the last three years, most factor indexes had higher absolute and active risk in both U.S. and developed-markets-ex-U.S., with absolute risk rising more sharply in the U.S. The exceptions were minimum volatility and quality, where the increase in absolute risk was less than the market, implying that these factor indexes retained their defensive characteristics.


Rising Risk in Factor Indexes


Despite Higher Volatility and Concentration, Stock-Specific Effects Did Not Dominate

Was higher risk in factor indexes driven mostly by factors? Or did high concentration result in overwhelming effects from the stock-specific component?

We found that higher absolute and active risks in factor indexes were driven by an increase in both style-factor and stock-specific risks. The ratio of risk contribution from specific-to-style-factor risk, however, was similar or, in some indexes, lower during the high-volatility/-concentration period (2018 to 2020) than the low-volatility/-concentration period (2015 to 2017), with a few exceptions, such as the MSCI USA Growth Target Index. Interestingly, for almost all the MSCI World ex USA Factor Indexes, the specific/style contribution ratio was lower during the more recent period. These results indicate that factors played a key role in driving risk in factor indexes and that stock-specific risks did not dominate, even as markets were getting more volatile and more concentrated, especially in the U.S.


Stock-Specific vs. Factor Contributions to Risk


Impact of Largest 10 Stocks on Factor Indexes

How has the fact that a handful of stocks accounted for a large proportion of returns over the more recent three-year period affected U.S. factor indexes’ performance? We assess the impact of the 10 largest U.S. stocks, by market capitalization, over this period.

These 10 stocks had overwhelmingly negative exposure to many of the style factors: low exposure not only to low size (they were larger companies), but also to value (were more expensive), yield (paid lower dividends) and low volatility (were more volatile) — and higher exposures, in aggregate, to quality, momentum and growth. The factor exposures of the largest 10 stocks in the MSCI World ex USA Index were, on average, slightly more positive and balanced compared to those in the MSCI USA Index.

The 10 largest stocks in each market were therefore, on aggregate, underweight in all MSCI USA and MSCI World ex USA single-factor indexes except quality and momentum, with the underweights larger for MSCI USA. This resulted in strong negative active-return contributions for low-size, value, yield and low-volatility factor indexes in the MSCI USA; less so for the MSCI World ex USA. However, common factors relative to stock-specific effects were larger contributors in the U.S. and global ex U.S.


Impact of 10 Largest Stocks on Factor-Index Active Returns from 2018 to 2020

In sum, we saw that, over the last three years, even as equity markets were getting more volatile and concentrated, factors played a key role in driving risk in factor indexes. Market-capitalization-weighted indexes can be concentrated in a few holdings, but diversifying into investment products based on factor indexes might have controlled stock-specific effects while also providing exposure to long-term risk-premia factors.



1Stock-specific effect relates to variation in stock returns that cannot be explained by systematic risk factors, such as countries, industries or style factors and is, on average, an uncompensated source of risk.

2The effective number of stocks is a measure of index concentration and ranges between 1 (for a single stock) and the number of stocks in the index (for an equal-weighted index). It is calculated as the inverse of the Herfindahl-Hirschman Index (HHI). The lower the EN, the more concentrated the portfolio.



Further Reading

Building Single-Factor Portfolios

How Diversified Are U.S. Equity Investors?