- Global investing provided risk diversification opportunities, as the crisis spread to different regions at different times and with varying intensity.
- Managing factors was more critical than picking stocks. Large performance variation across factors provided opportunities for active management. Index-based strategies played a key role in aiding price discovery and providing asset allocation tools.
- Companies with strong environmental, social and governance (ESG) characteristics suffered lower declines in relative terms during the crisis.
The coronavirus pandemic is redefining social attitudes, economic conditions, business practices and investment norms. In this blog post, we highlight five key lessons for investors. Please see our paper1 for more details.
Global Investing Provided Risk Diversification Opportunities
Governments, companies and investors benefited from capital flows across borders in different ways. Governments2 and companies3 were able to continue to access markets and raise funds at attractive rates during the crisis. For investors, global portfolios were less exposed to regional or sectoral troughs in performance, as the crisis spread to different regions at different times and with varying intensity. At the corporate level, companies with assets, revenues, supply chains and operations across multiple locations may have been more resilient to local disruption in economic and business activity. Following this crisis, risk diversification, in addition to revenue growth and cost reduction, may become an increasingly important driver of business and investment decisions.
Managing Factors Became More Critical than Picking Stocks
COVID-19 unleashed a surge of volatility, manifested in a torrent of sharp movements across global financial markets. Time series volatility increased significantly, but so did the cross-sectional variant. Importantly, cross-sectional dispersion attributed to common factors rose more sharply than stock-specific volatility. As a result, managing factor exposures became more critical than picking the right stocks. Avoiding airlines, for example, when the crisis struck was far more important than choosing between British Airways and American Airlines. Managing factors effectively during the crisis required technology-enabled, timely and accurate analysis of portfolio factor exposures at different levels of aggregation.
Rising Volatility Offered Active Management Opportunities
Markets have not been indiscriminate during the crisis. We witnessed large variations in performance across asset classes, market segments, regions, countries, sectors, industries, strategies, themes and individual securities. Sharp drawdowns in economically sensitive factors accompanied by small drops or even rallies in safe-haven assets, far from reflecting market panic, demonstrated a rational and discriminating reaction by investors. These declines provided opportunities for adding value and generating returns through active portfolio management.
Indexed Investing Enabled Active Portfolio Management
The large dispersion in performance across different segments and strategies during the crisis allowed investors to seek return enhancement and risk diversification opportunities. Many of these strategies could be implemented through exchange-traded funds (ETFs) and other index-tracking investment vehicles. Index-based strategies played a critical role in facilitating price discovery,4 promoting market efficiency and providing flexible tools that enabled active portfolio management in a rapidly changing market environment.5 Index-tracking ETFs generally remained liquid6 and provided transparent and efficient ways for investors to implement their active asset allocation decisions during the crisis.
Sustainable Investing Helped to Mitigate Drawdowns
ESG integration, the use of environmental, social and governance (ESG) factors in investment analysis and portfolio management, has gained increasing acceptance in the last few years as investors recognized the profound impact of environmental and social changes on long-term portfolios. We previously identified ESG characteristics as a potential way to mitigate systematic and idiosyncratic risk.7 The COVID-19 pandemic provided the first real test of this hypothesis. Companies with strong ESG characteristics suffered smaller drawdowns in relative terms. Importantly, attribution analysis showed that a large part of this relative outperformance came from ESG and was not merely a proxy for other defensive factors, such as quality and low volatility.8
Does the Crisis Strengthen the Case Against Globalization?
The COVID-19 crisis could accelerate forces of de-globalization. Companies may seek to simplify supply chains and rely on production at home. Governments may impose greater restrictions on the flow of goods, services, people, knowledge and capital across borders. Investors may be coerced or mandated to reduce their international portfolio allocations.
However, a global crisis is not necessarily a crisis of globalization. In fact, it could strengthen the case for globalization. Pandemics, like climate change, affect all countries and can be addressed more effectively through international cooperation. You cannot keep a deadly virus out of a country any more than you can prevent climate change from crossing national borders.
An important lesson from this crisis for investors and policymakers is that, far from shutting borders, drawing bridges and erecting barriers, international cooperation, trade and investment, sharing of knowledge, information and resources, combined with effective governance and prompt action, are the key to maintaining economic prosperity and mitigating the social, economic and financial impact of a future global crisis.
The author thanks Roman Kouzmenko, Zoltan Nagy and Navneet Kumar for their contributions to this post.
1Melas et al. 2020. “Five Lessons for Investors from the COVID-19 Crisis.” MSCI Research Insight.
2Smith, C. “US taps market for stimulus funds at historically low rates." Financial Times, April 3, 2020.
3Smith, R. “Why cruise ship-backed bonds drew $17bn of demand.” Financial Times, April 7, 2020.
4Wigglesworth, R. “All that drama about fixed-income ETFs was overplayed.” Financial Times, April 22, 2020.
5“ETFs have proved critics wrong during the crisis.” Financial Times, April 30, 2020.
6“Order amidst chaos: How ETFs perform in a volatile market.” iShares, Feb. 28, 2020.
7Giese et al. 2019. “Foundations of ESG Investing: How ESG Affects Equity Valuation, Risk and Performance.” Journal of Portfolio Management.
8“MSCI ESG Indexes during the coronavirus crisis.” MSCI Research Blog, April 22, 2020.