For the past decade, asset managers have been educating clients about factor investing as it became the new norm. And yet after all these years, portfolios are still composed of one factor: Equity Beta.
Among many questionable assertions and assumptions behind factor investing (our thoughts here, here and here), there is one that remains true: Equity Beta is the most significant Risk Factor in total portfolios and many “diversifying” asset classes.
[For the non-quant readers, Equity Beta and the associated equity risk premium is driven by its underlying connection to the Growth Risk factor. Negative economic growth surprises cause equities to drop while positive ones do the opposite. Because this risk is deemed ‘undiversifiable’ equity investors earn a positive return as compensation.]
Linking equity returns to the underlying macro-economic risk factors is as old as academic finance. It can be traced back to at least 1976 when Stephen Ross developed the arbitrage pricing theory (APT) as an alternative to the CAPM.
The one thing investors should have learned from a decade of attending factor investing conferences:
Any asset class that co-moves with the Economic Growth factor becomes similar to Equity Risk during a crisis because of that common link.
For example, high yield bonds have exposure to the Economic Growth factor and hence behave a lot like equities during crisis. Many High Dividend Yield stocks have the same problem, more so than typical stocks, because of high payout ratios and limited financial flexibility. That is why ‘stretching for yield’ is a risky thing to do.
Looking at March 2020 returns, the existence of a one-factor-world becomes a real possibility.
Everything that is traditionally considered diversifying, from international and emerging market equities, most fixed income, private equity, commodities, real estate as well as most styles of hedge funds and factor portfolios, were all linked to the same underlying Growth factor.
Even the liquidity driven shocks to prices seem to appear only when there is an unexpected and substantial risk to growth.
This is the reason why traditional static diversification continues to fail.
Even after a decade of learning about factor investing, investors still hold portfolios that are predominately driven by one factor: Equity Beta.And the simple U.S. 60/40 portfolio continues to crush the alternatives.
4. If Equity Beta is the “undeniable first factor” via its connection to Economic Growth, then, Interest Rates are the widely accepted “big second” via its connection to Inflation.
However, Inflation correlates with Economic Growth and although its impact on bond prices is in the opposite direction, we can still make a case that one factor moves everything else. When you couple lower inflation with FED’s easing and the ‘flight to safety’ trade - all of which lead to lower interest rates during growth shocks - the “big second factor” looks like an inverse of the “undeniable first”.
Risk Parity attempted to solve the one-factor problem by weighting Equity Beta and Interest Rate exposures more evenly than a standard 60/40 portfolio. However, in our long-run research on Risk Parity back to 1877 and during the March 2020 crash, we do not see empirically the advertised diversification benefits. Perhaps it is because Stocks, Bonds and Commodities, over the very long-run, all in their own ways depend on just one factor: Growth.
Could value investing, low-volatility, profitability and momentum also be connected to Growth? Yes, there is a certain amount of independent ‘zig-zagging’ that these other factors experience outside of their positive / negative correlation to Growth, but their contributions are so miniscule and their premia are so unreliable and often mutually cancelling (again likely due to the positive / negative exposures to Growth), that their impact on total portfolios is almost non-existent – especially during market shocks.
Take-away:
Q1 of 2020 really brought home the concept of the Equity Risk Factor. When Economic Growth came to a halt, alongside the expected equity market crash, almost every other type of investment declined sharply as well - from traditional diversified portfolios to risk parity, factor investing, most non-government fixed income and most commodities, private equity, real estate and the majority of hedge funds. On top of that people’s incomes have dropped sharply as well. After a shock like that, it is natural to question whether we truly do live in a one factor world.