As equity markets continue their COVID-19 pandemic roller coaster, understanding the technical dynamics may go a long way.
With the extreme and widespread volatility caused by the COVID-19 global pandemic continuing to roil markets world-wide, we can safely say it is too early to assess any manager’s performance in the current environment. That said, while both fundamental and quantitative active managers have struggled to outperform thus far, we thought it might be helpful to look at current market dynamics from a quantitative manager’s perspective given that what we’re seeing is primarily a technical drawdown.
When the Hedges Trim Themselves
First, while the extreme volatility has largely been driven by COVID-19 uncertainty, it was exacerbated by hedge-fund unwinding. As hedge funds de-levered, stock correlations spiked and valuation spreads widened to historical levels, signaling that investors were indiscriminately selling regardless of underlying fundamentals. Correlations between stocks, bonds, and gold also heightened, demonstrating signs of a flight to cash in favor of a flight to quality.
Against this backdrop, it is instructive to consider the winners and losers amidst the selloff. Companies in cyclical areas such as Energy and Financials declined the most while defensive areas like Consumer Staples and Health Care held up better, but not to the magnitude that would be expected. Other traditionally defensive areas, such as Utilities and REITs, posted results that were relatively average when compared to other sectors, leaving investors with few options.
Factors Don’t Lie and Occasionally the Truth Hurts
From a factor perspective, performance largely lined up with expectations. Large Cap stocks outperformed Small Cap, and Value underperformed Growth. Within Value, defensive signals, such as dividend yield, outperformed more cyclical signals, such as price-to-book. Furthermore, low beta outperformed high beta and quality exhibited defensive characteristics as companies with strong balance sheets, high profitability, and low leverage outperformed higher levered companies.
While factor performance was intuitive, the level of protection investors anticipated from defensive factors, such as low beta, fell far below expectations. During the selloff, traditionally defensive low beta funds were basically in line with the broader market, leaving quant investors with nowhere to hide. The low dispersion in performance amongst factors can be attributed to heightened volatility as well as elevated correlations resulting from the massive sell-off and de-levering from hedge funds. As a result, quantitative investors struggled - in some cases to a higher degree than fundamental - regardless of factor exposures. This is not entirely surprising given that most quantitative models struggle during inflection points.
The disappointing level of protection provided by low beta stocks stands in stark contrast to the surprisingly strong relative performance of Large Cap stocks. From February 19th through March 23rd, the Russell 1000 outperformed the Russell 2000 by roughly 6%, driven largely by mega-cap stocks in the index. For example, the three largest stocks in the Russell 1000, Microsoft Corp., Apple, Inc. and Amazon.com, Inc, fell 27.4%, 30.7%, and 12.3% from February 19 – March 23 versus over 40% for the Russell 2000 index. This unusually strong relative performance of mega-caps created an additional hurdle for both active and quantitative managers.
Staying Calm Through the Malaise
While anxiety understandably increases during periods of market distress, as long-term investors we cannot emphasize enough the importance of staying the course through the uncertainty. The need to remain disciplined became evident in the relief rally last week when markets rose over 15% in just three days. Perhaps unsurprisingly, the hardest hit areas were those that rallied the most. Reversals can be seen in metrics across Value, Quality, Growth and Risk, with the most significant reversals occurring in profitability and beta. Value began to outperform Growth, low quality outperformed high quality, and high beta outperformed low beta. Furthermore, Large Cap continued to show greater strength than Small Cap, albeit to a lesser extent. While we cannot conclude long-term trends from such a short time period, such data points demonstrate how difficult it is to time factors and the importance of remaining disciplined in periods of market distress.
While the rally has been welcomed, we are not in the clear yet and potentially have a long road ahead. Over the near-term, we anticipate continued volatility and elevated correlations, which could prove to be a headwind to active managers. However, over the long term, we expect market fundamentals to normalize, correlations to decline and the valuation gap to close.
This commentary has been prepared by Voya Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) changes in laws and regulations and (4) changes in the policies of governments and/or regulatory authorities. The opinions, views and information expressed in this commentary regarding holdings are subject to change without notice. The information provided regarding holdings is not a recommendation to buy or sell any security. Fund holdings are fluid and are subject to daily change based on market conditions and other factors.
Past performance is no guarantee of future results.