- Contrary to historical norms, the quality and value factors (typically negatively correlated) both outperformed in developed markets during the fourth quarter of 2019. High beta outperformed in emerging markets.
- For full-year 2019, all-time highs in equity indexes masked much dispersion in factors and sectors. Among stocks in the MSCI ACWI Index, the quality factor outperformed, largely driven by the technology sector outperforming energy by more than 35%.
- As of year-end 2019, our adaptive multi-factor model1 showed an underweight exposure to momentum and overweight exposure to value.
As we begin 2020, there are a few things we can declare with certainty: It’s a leap year; it’s a Summer Olympics year; and the title of this blog will be neither the first nor the last “2020 vision” reference you’ll see. On the other hand, the financial outlook for the year remained clouded by economic uncertainty, even before the recent flareup with Iran.
In this edition of Factors in Focus, we reflect on the historical relationships between factor returns and macro cycles, which have provided useful information for investors looking to take an active stance on factor exposures based on their outlook. Before we do so, however, we highlight certain factor returns over the fourth quarter and full-year 2019.
Quality and value outperformed in developed markets, high beta in emerging markets
The table shows regional variations 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 from Sept. 30, 2019, to Dec. 31, 2019.
Most global equity markets posted strong performance over the fourth quarter of 2019. For example, the MSCI ACWI Index returned 9.1%, bringing the full-year return of the index to 27.3%.
Developed markets (DM), were positive for stocks with higher quality and value factors, while stocks with a high beta factor fared relatively better in the emerging markets. In the previous Factors in Focus, we highlighted how the valuation spread between momentum and value in DM was the highest since the tech bubble. In the fourth quarter, value outperformed momentum in most DM regions.
All-time highs masked much dispersion over 2019
Looking over the year as a whole, many global equity markets reached all-time highs and experienced limited bouts of volatility, but underneath the calm surface, we saw a high degree of dispersion among factors and sectors.
- During the “slowdown” phase (as measured by our composite macro indicators) from Q1 to Q3 2019, the quality and momentum factors outperformed similar to their historical patterns (see the exhibit below).
- At the end of August, the momentum factor had the highest valuations vs. the value factor since the tech bubble of the early 2000s.
- During the first two weeks of September — when some factors experienced sharp reversals — the value factor outperformed the momentum factor by nearly 7%.
- Information technology (IT) within the MSCI ACWI Index was the leading sector over 2019. Growth and quality factors were key drivers of IT-sector performance, while the underperforming energy sector had relatively low growth, momentum and profitability factor characteristics.
Quality and momentum factors outperformed
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 Q4 and full-year 2019.
It’s clear from a 2019 full-year perspective that quality was the top factor, while value and low size factors were underappreciated. Quality’s advantage was largely driven by overweight exposure to technology-sector stocks — the best-performing sector in the MSCI ACWI Index — and an underweight to energy.
35% return spread between technology and energy factors
Active returns of stock sectors vs. the MSCI ACWI Index for Q4 and full-year 2019.
Factor performance across economic cycles
Style factors have been key drivers of equity returns over the long run. However, factor premia have been time-varying and delivered their performance at different points in the macro cycle. The exhibit below tabulates information ratios (IR) of the MSCI ACWI Factor Indexes over historical timeframes as well as macroeconomic cycles. As a proxy to measure macroeconomic cycles, the macro states reflect changes in and absolute levels of the U.S. PMI, and we measure the subsequent performance of factors conditioned on the level of the indicator at the start of the holding period.
All MSCI ACWI Factor Indexes delivered positive IRs over the full analysis period of Dec. 31, 1998, to Dec. 31, 2019. Over shorter periods, however, distinct patterns emerge. During a “slowdown” phase, quality and momentum were lead performers, while size and value were laggards — consistent with the overall performance during 2019.
Factor performance (information ratio) differed across shorter periods
Full history corresponds to Dec. 31, 1998, to Dec. 31, 2019. The macro regime is decided based on the current value of PMI-50 and the three-month change in PMI. Change>0, Level<0 = Recovery. Change>0, Level>0 = Expansion. Change<0, Level>0 = Slowdown. Change<0,Level<0 = Contraction.
Top-performing factors in major macro regimes
Data from Dec. 31, 1998, to Dec. 31, 2019. The macro regime is decided based on the current value of PMI-50 and the three-month change in PMI. Change>0, Level<0 = Recovery. Change>0, Level>0 = Expansion. Change<0, Level>0 = Slowdown. Change<0,Level<0 = Contraction.
Looking at factor valuations using the MSCI Factor Indexes over the last 20 years, we found that the enhanced value factor had very low valuation, while the quality factor had the highest. The momentum factor, which we found was overvalued in the last Factors in Focus, has seemingly corrected since then (as shown by its z-score going down to 0.81 from 1.5).
Relative valuation ratios of MSCI Factor Indexes
Data from Dec. 31, 1998, to Dec. 31, 2019. In the first step, the ratio of each individual valuation metric (P/B, P/E, P/CE) for each factor index over the same valuation metric of the parent index is calculated. Next, all three ratios are z-scored over the entire timeframe and the average of these three is plotted.
What about 2020? Will the value vs. momentum battle continue?
While we cannot predict what will happen in 2020, our research has shown factors have historically been sensitive to broad and changing market conditions, such as the macro environment, valuations, recent performance trends and risk sentiment.
As of Dec. 31, 2019, our adaptive multi-factor model showed the following exposures across the four pillars:
- The macro cycle pillar indicated a mixed signal between contraction and recovery and overweighted low volatility, quality and value, based on the Chicago Fed National Activity Index, the 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 value, quality and low size, based on the last three months’ relative performance.
- The market sentiment pillar showed a mild overweight to low size, momentum and value, based on contained credit spreads and an upward-sloping Cboe Volatility Index (VIX) term structure at the time of reference.
Exposures from MSCI’s adaptive multi-factor allocation model
As of Dec. 31, 2019. Positive exposures are denoted as + or ++, negative as - or --, neutral as N.
Overall, our adaptive multi-factor model observed an overweight to value, a mild overweight to low size, a mild underweight to momentum, low volatility and yield, with quality being neutral relative to an equal-weighted mix. Despite quality having had high valuations, it was overweight from a macro and momentum perspective, and resulted in an overall neutral exposure.
1Varsani, H. and Jain, V. 2018. “Adaptive multi-factor allocation.” MSCI Research Insight.
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Adaptive multi-factor allocation