Rewarded risk factors are recognized as a fundamental component of equity returns. Envestnet | PMC believes that the most robust among the studied risk factors are value, momentum, quality, low volatility, and size. Like all return components, factors are cyclical in nature. Below, we take a look at the performance of these factors in the current market environment.

How factors have fared

The curtain has fallen on what proved to be the most tumultuous first half of a year in decades for the markets. Though long-only equity factor indices ended in the red along with the broader equity markets, their relative performance followed expected patterns, with an important caveat on the quality factor.

The quality and minimum volatility long-only factors have seen somewhat of a divergence so far this year. Though their long-term positive correlation remains, the mere underperformance of the quality factor relative to the broader equity market is puzzling given the distinctly risk-off environment.

We continue to posit that the underperformance of the long-only quality index is tied at least in part to a “baby with the bathwater” rotation away from the high growth technology sector. The tech sector as a whole tends to have better quality characteristics but underperforms when rates are rising.

This counterintuitive result for the quality index underscores an important consideration when investing in long-only factor products. The quality risk premia, as all factor premia, is created through a long-short portfolio – long high-quality stocks and short low-quality stocks – to eliminate the impact of the broad market and isolate the return of the pure risk factor. The quality premia has in fact been positive and behaving as would be expected in a risk-off environment. However, most factor-based indices and exchange traded products are long-only, resulting in higher market exposure that can sometimes overshadow the risk premia itself over short time horizons. For a deeper dive on this topic, see this quarter’s Factor Insights update.

In general, however, the broader quality factor is positioned to perform well. High inflationary environments tend to favor more profitable companies, and quality tends to perform well in late cycle environments characterized by slowing demand and higher rates.

Not surprisingly, minimum volatility has been a top performing factor here and abroad in the face of heightened market volatility and a general appetite among investors for less risky assets.

The rotation to value is now squarely underway globally. For the year-to-date and trailing one-year period, it lags only the minimum volatility factor domestically and leads almost all factors internationally. Value is also handily ahead of the growth factor over these periods.

Recent outperformance for value versus growth names has helped lessen the relative performance gap between them over intermediate periods. However, much ground remains to be made up over the long term, given the strong preference for growth in the low interest rate, high risk-seeking environment that existed for years prior to the recent rotation to safety and a rate-tightening regime.

As seen in previous cycles, value tends to do well in the face of higher inflation and rising interest rates, both undoubtedly on the menu as global economies recover from pandemic-fueled supply chain disruptions and a fiscal and monetary stimulus-fueled bull market.

Momentum struggles in shifting markets, and likely won’t find its footing until inflation, central bank policies and a host of other uncertainties resolve themselves and markets enter a more consistent trend. Of course, the timeline for any of this to come to fruition is unclear.

Long-short and long-only factor-based portfolios rarely track each other because of differing exposure to the market risk premia. To learn more about these approaches, check out a deeper dive in this quarter’s Factor Insights update.

Past performance is not indicative of future results. The information, analysis and opinions expressed herein are for informational purposes only and do not necessarily reflect the views of Envestnet. These views reflect the judgment of the author as of the date of writing and are subject to change at any time without notice. Nothing contained in this piece is intended to constitute legal, tax, accounting, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type.