In the world of investment jargon, knowing this force and how it will impact any strategy is massively important. On the anatomy of factor performance under economic trends (Jonathan Butler, Ritchie S. King, and Douglas Zahkem)Understanding how large-scale shifts in macroeconomic variables can wash through broad equity markets and influence returns to value factors is an important question—the author uses a combination of univariate sorting analysis at business cycle turning points using two natural breaks that are partitioned into six subperiods each based on Federal Reserve Board estimates for U.S. recessions between 1971-2019ToAdd this randomized content here…This article examines whether changes in investor tolerance for risky exposure during different parts.
Understanding Factor Investing
But before we round up the macroeconomic factors that drove these behaviors, let’s briefly revisit what factor investing is. Factor investing is a systematic, risk-based approach to tilt portfolio exposures toward forecasted sources of excess returns across broad asset classes at relatively low fees. Common factors include:
Value: Buying Cheap Assets
Momentum — Riding existing market trends
Focus on Good Quality Companies;
Size: Focused on small growth companies
Beta: This can be seen as investing in “safer” asset classes that have less price volatility
All those factors have a long history of being able to outperform the broader market (albeit over different timeframes). But, as with most investments, It is a pro-cyclical job and hence may provide very good returns when economic recovery is in place.
The Macroeconomic Landscape
Figure 1: An Overview of Macroeconomic TrendsMacroeconomics is a large and complex field that touches on so much — here are just some things you can study.
GDP growth
Inflation rates
Interest rates
Employment levels
Global trade dynamics
Fiscal and monetary policies
These are the contexts in which all investments play, and their changes can be material to factor returns.
The Interplay: How Macro Trends Affect Factor Returns
Value Factor
Value is performing well when economic recovery becomes obvious and inflation does not exceed 2%. When the economy is doing well, undervalued companies can prove their worth which pushes up their price as people realize that what they fell on is now way below value.
That being said, when rates are so low and economic growth is tepid — as it has been for the past decade or more now in much of the world -— over time value stocks can underperform. In the decade after 2008, for example, growth stocks shot ahead of value in many markets!
Momentum Factor
Momentum strategies work when markets — in the case of oil, COMEX Crude Oil, anyway — are trending higher or lower. During periods of robust economic expansion — or contraction, for that matter –the trends generally come out more crystal clear, which in turn is an advantage to momentum investors.
However, when market sentiment is changing quickly or economic data less certain momentum strategies can get crushed with whipsaws and false signals.
Quality Factor
In times of recession or just heightened uncertainty, quality stocks tend to outperform. Firms with substantial levels of cash, more predictable earnings, and sound efficiencies are far less susceptible than average.
On the other hand, in periods of strong economic growth and risk appetite, these quality stocks could lag as investors chase greater returns with more risks.
Size Factor
Historically, small-cap stocks have generally done well when economic growth has been running in the right direction and risk appetite is high. In favorable economic conditions, due to being smaller and nimble than their larger rivals, small businesses can grow more rapidly.
However, as you have seen during economic contractions or in times of significant market stress, the size factor can be a laggard with insecure investors flocking to the purportedly safe large-cap companies.
Low Volatility Factor
Low volatility is typically a high-demand factor during downturns and weak economic times. When the broader market is volatile, investors turn to low-volatility stocks because they are generally more stable and therefore reliable.
On the other hand in aggressive bull markets or fast expansions; low volatility stocks may lag as investors perhaps chase returns meaning stability way-weighed by local growth.
Implications for Investors
Several major implications for investors emerge from an understanding of the interplay between macro trends and factor returns.
Diversification is critical: As factors vary from one cycle to the next, a multi-factor approach can help even out returns across different macroeconomic conditions.
It is also timing: it should be difficult and tricky but certain macroeconomic regimes can give clues as to how investors could want their factors tilted when investing.
Take a longer view: Finally, remember that factor premiums work over long time frames. Broadly speaking, short-term macroeconomic swings shouldn’t be the deciding factor on whether to alter your investment process across an entire strategy based upon a given factor.
Political over economic risk: These cannot be modeled, but can probably be understood through common sense; we get unexpected political outcomes due to the very fact that they are not model-able from macroeconomic conditions The Answer is in Diversification Adaptive strategies some advanced investors adapt factor exposures based on indicators of prevailing market regimes (state October 1987) While these methods can make a great impact, they should be implemented cautiously and need to monitor at regular intervals.
Supplemental research: By overlaying a mix of factor analysis and macroeconomic understanding, we aim to create a comprehensive context for broader insights on the landscape where investment opportunities can be pursued as well as potential risks in which they need mitigating strategies.
Conclusion
The relationship between macroeconomic trends and factor returns can be nuanced, complex… inevitably all of the above. While some tendencies have been seen as ‘typical’, past performance is not indicative of future results. Since the global economy is a dynamic system, what past performance suggests about how macro trends are generally related to factor returns may not remain true forever.
As an investor, the important thing is to stay watchful and flexible. This awareness of the impact macroeconomic forces can have on factor performance enables investors not only to follow a more informed asset allocation strategy but also to better manage risk and increase their chances for higher long-term returns.
Remember, like with any investment strategy, it is important to match the strategy against what makes sense for you and your individual goals & risk tolerance &&investment horizon. Seeking guidance from a financial professional may help you traverse the minefield that is factor returns and macroeconomic trends on your investment path.