The concept of a normalized investment cycle has come under pressure in the post-Global Financial Crisis era due to years of sustained quantitative easing, financial repression and lower trend growth. Experts from FTSE Russell and Invesco gathered virtually for a multi-factor exploration to dissect which properties of the business cycle have endured. Addressing this in their recent webinar, panelists take a look at macroeconomic factors, historical factor performance, and consider the stability of assumptions in today’s market environment.
Setting the stage, recent research by FTSE Russell’s head of investment research, Marlies van Boven, shows how factors can anticipate inflections in the economic cycle. We associate next year’s growth in GDP with the prior year’s annual factor returns. Low economic growth is defined as the bottom 25% of future GDP growth outcomes; high growth as the top 25% of future GDP growth observations. The graph shows the grouping creates three distinct states of economic growth.
Key findings of this research reveal Size and Value have anticipated subsequent inflections in GDP growth whereas Quality has anticipated economic contractions, and Momentum seems to provide little information about the macro economy.
Linking factor performance to economic cycles, van Boven describes how the use of the Investment Clock can guide factor rotation since factors differ in their sensitivity to economic growth and inflation expectations. The table below shows the risk-adjusted returns, Over a 60-year period from Q3 1958 to Q2 2020, Quality tended to do well from the peak of the cycle and into a contraction. During times of economic recovery, Value, Size and Momentum tended to be the best performers, but even into periods of expansion, Size and notably Momentum continued to do well.
Evaluating the timeline post-GFC compared to the full 60 years, we see stronger market performance with lower average factor payoffs, which combined with higher volatility leads to lower risk-adjusted returns. Further Analysis, in Part 2 of the series, shows 12 years of secular stagnation with quantitative easing and negative rates has dampened the volatility of the economic cycle.
Drawing on van Boven’s observations, fellow panelist Alessio de Longis, Invesco’s senior portfolio manager and head of global tactical asset allocation, categorizes how factors exhibit cyclicality and different exposures to economic risk, noting:
- Size and Value tend to be cyclical, with higher operating leverage and more reliance on external funding
- Quality and Low Volatility tend to be defensive, with lower operating leverage and more reliance on internal cash flows
- Momentum is more transient and tends to perform well in later stages of cyclical upturns and downturns
“Factors lead, rather than respond to the actual GDP growth,” notes de Longis. “Therefore, it’s critical to devise an investment strategy that seeks to reposition factor exposures based on the anticipation of future economic regimes, rather than reacting to current or past economic developments.”
Reviewing simulated performance and risk from December 31, 1989 to December 31, 2020, de Longis explains that while average factor outperformance relative to the market has diminished in the post-GFC period, the cyclicality of factor performance has increased, in line with more pronounced recessions and rebounds in economic growth. This indicates factors are more responsive to gyrations in the business cycle.
With increased interest in dynamic multi-factor strategies, Invesco’s head of factor and core equity product strategy, Nick Kalivas, details different ways investors are implementing multi-factor ETFs within their portfolios. Some combine them with market cap to access timely factor exposure while managing tracking error that inherently comes with factor-based investing. Others use the ETFs as an anchor to diversify and complement other active or passive strategies. “There’s also quite an appetite among investors to manage the economic cycle and maximize their investment returns,” notes Kalivas. “For that, the dynamic multi-factor process driving the ETF can be used to tilt more aggressively during periods of an accelerating economy and can be tilted defensively in times of a troubled economic environment.”
Visit FTSE Russell’s BrightTALK channel for a full replay of the webinar, "Time is money – QE and the investment cycle – A multifactor exploration." More information on Marlies van Boven’s research and the behaviors of factors across economic cycles can also be found in Part 1 of FTSE Russell’s recent Investment Clock series, "Linking factor behavior to the economic cycle." For a deeper dive linking factor behavior to secular regime shifts in the US market, read Part 2 – "New thinking: Rebooting the Investment Clock for the new normal and QE regime."
Co-developed with Invesco and built using FTSE Russell’s innovative "Tilt-Tilt" methodology, the FTSE Invesco Dynamic MultiFactor Index Series uses economic and market sentiment indicators to identify four regimes corresponding to different parts of the business cycle and targets a combination of factors that have historically outperformed others throughout these stages. Learn more about the index series on FTSE Russell’s website.
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