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Factor strategies beyond a market peak

By Marlies van Boven, managing director, research and analytics, and Philip Lawlor, managing director, global markets research

After a stormy Q4 in 2018, investors are pondering fundamental questions about global markets.

As our global markets research team has previously noted, there are concerns that we are at, or past, the peak of the economic cycle. Investors are also questioning the impact of tightening US financial conditions on the financial system and are worried about potentially optimistic EPS valuations at this point in the cycle.

Historical comparisons of key leading indicators, which have a direct bearing on asset allocation framework, support the notion that we are close to or past the peak. The US ISM Manufacturing Index and European Economic Sentiment Three Month Moving Averages appear to be at their highest point, and the US yield curve is flat and close to inverting.

 

If, in the commonly used metaphor of the investment clock as an illustration of the economic cycle, we are around or past midnight (see chart below), investors will consider rotating into more defensive assets.

The performance of different factors can be demonstrated by looking at Russell 1000 Single Factor Indexes in recent years. Quality and Low Volatility outperformed during the Global Financial Crisis, as investors became risk averse. In the subsequent bull market, risk was back on the table and Small Cap stocks outperformed.

In the second half of 2018, as equity market volatility increased, there was a rotation away from Small Cap stocks into more defensive Large Cap, Quality and Low Volatility stocks,

However there is an alternative strategy that has protected investors in downside markets: Minimum Variance.

Minimum variance is not to be confused with the low volatility factor. The latter is a risk factor strategy with an explicit objective to enhance return by capturing the low volatility factor premium. It is a defensive strategy that tends to work well during economic slowdowns and when investors become risk averse. Minimum Variance is a risk management strategy with no explicit return target, with the sole objective to minimize index volatility; overall, minimum variance has demonstrated a very consistent risk reduction.

Minimum Variance is potentially a suitable overlay strategy for investors who have an equity portfolio but want to temporarily reduce the effect of market volatility in their portfolio while maintaining exposure to the equity market. It works particularly well during periods of increased volatility and investor risk aversion, providing downside protection.

As the chart below shows, during the Global Financial Crisis, a minimum variance strategy reduced volatility relative by more than close 20% compared with a low volatility index.

Quality and Low Volatility factor indexes capture the risk premium associated with these defensive strategies and they reduce downside risk relative to cyclical strategies and perform well when risk aversion is high.

Alternatively, a minimum variance index is focused on minimizing index volatility, allowing investors to maintain equity exposure with lower volatility. If the turbulence we've seen in late 2018 continues, investors may very likely focus more of their attention on one of these two strategies.

 

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