Typically, when we think of defense and risk aversion, we think of countercyclical exposures, where the focus is on certainty on earnings, stable and strong fundamentals, and/or low price volatility. This is separate from our view on factors utilized for capital appreciation, such as growth or value factors. In Figure 1, we show the down-market capture (DMC) for commonly used factors in the US and Europe over the long term and during the market sell-off between February 18 and March 23. The numbers indicate how much of the down-market return the factor “captures.” For example, if the market was down 10% and the DMC was 60%, the factor return was -6%.
A couple of key observations from the data:
- Not surprisingly, the value-oriented factors captured more of the downside. Also, DMC was consistently high across regions and value types, including during the COVID-19 sell-off.
- Over the longer term, companies with high revenue and expected earnings-per-share growth tended to be more cyclical (DMC >100%), while quality growth companies (i.e., companies that grow their capital base at high economic rates of return) were slightly defensive. Factor behavior in Europe during the recent sell-off approximated long-term trends, but this was not the case in the US, where all three flavors of growth held up much better than they have historically, with DMC at or below 100%.
- Getting to the core of the issue, quality and risk-aversion factors saw a significant change in behavior in the recent episode, although it was more pronounced in the US. For example, the profit stability factor moved from a very defensive profile (64%) to being only marginally defensive (91%). European defensive factors fared better, retaining most of their defensive characteristics.
Importantly, if we focus on the change in behavior during the recent drawdown versus history, the degradation in the US defensive factors is most striking. For example, US low volatility captured 60% more downside in the recent sell-off relative to history. Growth factors held up much better than expected, cutting 30% of their down capture and essentially matching market returns. The only notable results in Europe were that low P/B did better than it has historically (although it still underperformed in the period) and dividends (even the sustainable dividends factor) had a much higher risk orientation.
Why did defensive factors not hold up like history would suggest? We believe there may have been several key drivers:
- In the first stages of a liquidity event, hedge funds seeking to reduce gross exposure typically sell higher-quality long exposures and buy back lower-quality short exposures — regardless of fundamentals.
- As investors sell equities to raise cash, the price impact on stocks is generally commensurate to each stock’s liquidity — so smaller-cap and less-liquid holdings tend to see a larger price impact regardless of fundamentals.
- Low-volatility stocks were a crowded trade, which may have seen selling pressure as allocators reduced their equity exposure.
- Stocks that are typically in the domain of growth (not quality), such as those with capital-light business models, high profitability, and low cost of capital, justified their higher valuations and did not sell off as hard as history would suggest.
- In this drawdown, industries that typically feature prominently for defensive factors, such as insurance, real estate, and restaurants/leisure, underperformed, while higher-risk and cyclical areas, such as biotech, transportation, and software, outperformed. This behavior is unexpected if the immediate concern is an economic slowdown, but it makes sense in the context of a global pandemic with everyone at home.
- Higher-quality dividend stocks have also not protected as much as they have in the past. As we see more direct government support (and with it, political pressure around supporting employees versus shareholders), we could see companies cutting dividends (instead of payrolls) in order to stay solvent in the short term.