Central banks assume an outsize role in the intricate web of global finance and investment. That is especially the case for how it shows up in investment factor performance (a topic I could write a book on, and yet goes largely ignored). Watch: Learn more about how central banks and the broader market can drive factor investing in our whitepaper here, designed for both experienced investors and newbies to factors.

Understanding Factor Investing

But before we examine the role of central banks let’s quickly recap on what factor investing is. Factor Investing is an investment strategy that targets specific drivers of return across asset classes. Common factors include:

Value: The Set of Undervalued Assets

Momentum… bought or sold in the right direction

Quality: Investing in fundamentally strong companies

Targeting: Smaller companies with science that holds upside potential

Risk Averse: Looking for Low Volatility Assets

All have shown historical performance that, on average and over longer timespans, can beat the market but in practice work differently during various economic stages than others.

Central Bank Policies: The Puppet Masters of Financial Markets

Central banks — like the Federal Reserve in the U.S., the European Central Bank, and the Bank of Japan, among others — play a vital role in influencing economic circumstances using different policy measures. Some of the most specific cases include

Interest Rate Adjustments

Loose or Tight Quantitative Easing (QE)

Forward Guidance

Reserve Requirements

These policies can impact everything from inflation and economic growth to investor sentiment and risk appetite. Therefore, they impact the performance of various investment factors.

The Interplay Between Central Bank Policies and Factor Performance

Interest Rates and Value Factor

Lower interest rates tend to increase borrowing and spending, which can stimulate the economy; In such a world, value is often the underperforming part of equities as investors chase growth. On the flip side, value stocks typically take over when interest rates spike — cash flows of book-value-based companies are more reliable and/or safer opportunities as opposed to growth.

Quantitative Easing and Momentum Factor

Under quantitative easing, central banks usually buy up large amounts of securities to provide added liquidity in the market so more money is available; in insecurities markets this often causes asset price inflation Such an environment is a boon for the momentum factor — wilting and withering away in more normal times, but thriving when markets are going up-for-no-good-reason-except-there-is-too-much-money thing.

Forward Guidance and Quality Factor

How central banks guide financial markets, i.e. their “forward guidance”, can thus play a key role and condition how these expectations spread into the remainder of the economy (Reis 2019). A factor that typically does well in times of uncertainty or when central banks indicate potential economic downturns is the quality I.e Quality Factor. In this kind of environment, investors look for earnings predictability and strong balance sheets; where dividends are paid they should be supported by decent standalone fundamentals.

Reserve Requirements and Size Factor

The bank’s lendable capacity is reduced; however, if reserve requirements are raised. Relaxing requirements could result in more lending, which would especially help smaller firms that get most of their funding from banks. That can, in turn, be fertile ground for the size premium.

Overall Monetary Policy Stance and Low Volatility Factor

Low Volatility: The broad stance of monetary policy (i.e., rate accommodative or restrictive) can also affect how the low volatility factor performs. During accommodative periods, when the risk aversion is paradise (*) and we are feeling too lazy to look for an alpha strategy — or even worse: two steps ahead on Sunday afternoon — low volatility stocks can suffer from a relative perspective given that investors turn their trackball into profitability mode. Alternatively, under a tightening cycle low volatility stocks tend to outperform as investors are more risk-off.

Real-World Examples

A great example of this is the post-financial crisis (2008) period, where we can see how central bank policies have influenced factor performance. The Federal Reserve’s zero interest rate policy and its large-scale quantitative easing program resulted in a period where growth stocks — particularly technology companies as the key driver for value valuations too during recent years — outperformed value by a historically wide margin.

And most recently, the quickening pace of central bank interest rate hikes around the world in response to inflation has driven a revival of value factor performance. Rising rates have made low, stable cash flows from value stocks more attractive relative to the future profit potential of some hot tech names.

Implications for Investors

Investors can take advantage by understanding how factor performance on a broad scale is related to central bank policy, to better inform portfolio construction and risk management. Some key takeaways include:

Factor diversification helps counteract the effects of policy changes on portfolio performance.

To better manage the risks posed by central banks it makes sense to reassess factor exposures regularly so that risk-return characteristics are maintained.

The use of factor analysis along with an insight into the broader macroeconomic environment can enable better investment decisions.

Conclusion

Central Bank Policies vs Factor Performance: A Tricky Relationship It is worth noting that historical trends provide only generalizations, as any economic cycle has distinct characteristics with factors often behaving divergently depending on the circumstances.

Although central banks will confront different economic landscapes in the coming months, such as inflation and geopolitical risks still being a key focus for many factor investors. Investors who understand the factors and determinants of central bank policies are in a better position to make use of factor premiums while navigating downside risks.

No matter in which direction markets move next, the interaction of central bank policies with factor performance will surely remain an important field for further research to every investor who is eager to fine-tune their portfolios for long-run success.