With the zeal of a resolution writer, investors started 2018 with great optimism. But the year in full produced a cloud of uncertainty. And as midnight struck on New Year’s Eve, market volatility had reset higher coupled with steep market corrections, as investors adjusted to trade wars and intensifying concerns about a possible global economic slowdown, as well as uncertainty about European politics and the prospects for future rate hikes by the U.S. Federal Reserve Board.
In this inaugural Factors in Focus, we highlight the fast-moving rotation among factors that may have impacted investor portfolios during 2018, and we look to indications from our adaptive multi-factor framework. As 2019 began, this framework showed an overweight allocation to minimum volatility and quality, an underweight allocation to value, low size and momentum, and a neutral position on high dividend yield relative to a six-factor equally-weighted mix.
2018 saw fast-moving rotation among factors
Shows full-year and semi-annual active return (%) performance of the MSCI ACWI Minimum Volatility (USD) Index, MSCI ACWI High Dividend Yield Index, MSCI ACWI Quality Index, MSCI ACWI Momentum Index, MSCI ACWI Enhanced Value Index and the MSCI ACWI Equal-weighted Index from Dec. 31, 2017 to Dec. 31, 2018.
January through June: momentum and quality led the way
Equity markets got off to a flying start in January 2018 (the MSCI ACWI Index returned 5.66% and the MSCI Emerging Markets Index 8.34%) before market sentiment reversed and the CBOE Volatility Index (VIX) surged from 12.5 in early February to an intra-day peak of 41.06 on Feb. 9, 2018. While the extreme bouts of (implied) market volatility were somewhat unrelated to growth fears and cross referenced the infamous short-volatility unwind, market volatility remained elevated and spiked again in March. By the end of Q1, the MSCI ACWI Index returns dropped to -0.84% and the MSCI Emerging Markets Index to 1.47%.
Looking at factor performance, momentum, which has historically faltered during volatile markets, was the leading factor performer during the first quarter of 2018. The quality factor, which has outperformed around VIX spikes (see exhibit below), also outperformed.
VIX spikes have led to “flight to quality” factors
Data based on performance of the MSCI ACWI Quality Index and the VIX from Jan. 1, 2010 to Dec. 31, 2018.
By the end of the first half of the year, developed market equities recovered some ground, following resilient economic data and a strong earnings season, while emerging markets recorded sharp falls given significant headwinds from prospects of Fed rate hikes and U.S. dollar strength. Rising trade tensions added further pressure on Asian emerging markets. Meanwhile, momentum and quality factors continued on a positive trend, while low size and value turned in lower performance.
June through December: the rotation to defensive factors
Steady global growth supported by above-trend growth in the U.S., helped continue the recovery in developed equity markets as the second half of 2018 began. (The MSCI World Index returned 5.10% for Q3.)
During this time, the momentum factor benefited from underlying trends, and defensive factors, including minimum volatility, outperformed, despite core government bond yields rising. Moreover, as we see in the exhibit below, the correlations between active returns of the MSCI USA Minimum Volatility Index and changes in 10-year U.S. Treasury yields had been highly negative when rates were falling (2007-2016). However, the correlations in the last three years showed signs of being similar to the previous rate-rising cycle (2003-2007).
Correlation between the MSCI USA Minimum Volatility Index and US Treasury yields
Data depicts a 1-year rolling realized correlation based on monthly active returns of the MSCI USA Minimum Volatility Index and the 10-Year Constant Maturity US Treasury Yield from Jan. 1, 2000 to Dec. 31, 2018.
By the end of 2018, volatility reset higher and coupled with steep market corrections across global markets. Despite relatively muted performance for the first nine months of the year, minimum volatility turned out to be the leading factor performer across developed and emerging markets for the full year. High dividend yield posted strong outperformance in emerging markets and Asia ex Japan.
Minimum volatility led the pack in 2018
Shows regional variations of the MSCI ACWI Minimum Volatility (USD) Index, MSCI ACWI High Dividend Yield Index, MSCI ACWI Quality Index, MSCI ACWI Momentum Index, MSCI ACWI Enhanced Value Index and the MSCI ACWI Equal-weighted Index from Dec. 31, 2017 to Dec. 31, 2018.
Reviewing the year with adaptive multi-factor allocation
Following such heightened dispersion in factor returns in 2018, investor attention may have turned toward their factor exposures for this year. With this in mind, we revisited our framework for adaptive multi-factor allocation, which is centered around adapting factor allocations based on four pillars: Macro Cycle, Valuations, Momentum and Market Sentiment (monthly rebalancing).
Over the course of 2018, our simulated adaptive composite strategy exposure shifted from cyclical to defensive factors and outperformed the MSCI ACWI Index by 1.0% for the full year (in line with the six-factor equally weighted mix). Factor rotation within the Macro Cycle and Momentum pillars led to outperformance of 2.4% and 2.8% respectively versus the MSCI ACWI Index, as shown in the exhibit below.
Active return of the four adaptive multi-factor allocation pillars and composite
Data from Dec. 31, 2017 to Dec. 31, 2018.
What about 2019?
As of Dec. 31, 2018, our adaptive multi-factor framework showed the following exposures across the four pillars:
- Macro Cycle indicated a bias toward a “slowdown” and overweighted momentum, minimum volatility and quality, based on the Chicago National Activity Index, the Federal Reserve Bank of Philadelphia ADS Index and the Global Purchasing Managers Index.
- Valuations overweighted value and low size, based on the valuation gap compared to an equal-weighted factor mix in the context of 40 years of a factor’s history.
- Momentum selected minimum volatility, high dividend yield and quality, based on recent performance.
- Market Sentiment overweighted minimum volatility, high dividend yield and quality, based on rising credit spreads and an inverted VIX term structure at the time of reference.
Exposures from MSCI’s adaptive multi-factor allocation framework
Data as of Dec. 31, 2018. Note: Indicators highlight overweight and underweight index positions relative to an equal-weight six factor index mix
Minimum volatility turned out to be the leading factor performer across developed and emerging markets in 2018. As of the end of the year, our adaptive multi-factor framework told a different story. Factors in Focus, a new series from MSCI, will continue to report on the markets through the lens of factors throughout 2019..
The authors thank Waman Virgaonkar for his contributions to this blog post.