Scientific Beta: Equity factor performance in 2021

5 april 2022

By Daniel Aguet (photo) and Maurizio Luisi, respectively Index Director and Deputy Index Director at Scientific Beta

After a particularly volatile year in 2020, during which the performance of some equity risk factors such as Size and Value was particularly affected by the consequences of the outbreak of COVID-19, the average performance of the six rewarded equity factors based on academic consensus, namely Size, Value, Momentum, Low Volatility, High Profitability and Low Investment, was positive across all regions in 2021, with a +2.9% return on a Global basis.

The Value factor benefited from the recovery of companies with high tangible assets, such as Utilities or Energy companies, which were particularly affected by measures set up by governments to fight the pandemic, such as lockdowns. The Size factor performed positively as well, as the re-opening from the COVID-19 restrictions bolstered risk-on positions and investors’ confidence in the economic recovery.

Bad times for the factor Momentum

While Value and Size recovered from their considerable 2020 losses, Momentum had a particularly difficult year, especially in the US region, with a negative performance of -22.2%, which is one of the most extreme 1-year performances over a 45-year historical sample.

As the composition of the Momentum factor might vary strongly from quarter to quarter, and since its composition depends on stocks’ past performances, sector allocation might be very volatile and concentrated, exposing the Momentum factor to macroeconomic risks over the short-term. Momentum’s poor performances were concentrated in the first quarter of 2021 and were mainly due to sector allocations.

Indeed, it was under-exposed to the Energy and Financials sectors and over-exposed to Technology companies, which were the main outperformers of 2020, since they were less affected by the lockdown measures imposed by governments. However, over the first quarter, Energy and Financials outperformed the broad cap-weighted benchmark by 25% and 9% respectively, while Technology underperformed by 3%.

The role of inflation

Inflation in the US rose faster than expected in 2021, reaching a near 40-year high at the end of the year. With inflation accelerating beyond expectations, the year was dominated by positive unexpected inflation shocks measured by the weekly change of 10-year breakeven inflation, which is the difference between the 10-year yields of Treasury Inflation-Protected Securities and Treasury Securities.

Over the long-term, the exposure of the Momentum factor to inflation surprises is not statistically and economically significant. However, over the last few years, this exposure became negative and statistically significant. This is a direct consequence of the Momentum factor’s sector allocation. Indeed, both the Financial and Energy sectors tend to react positively to inflation surprises while Technology tends to react negatively.

Consequently, the Momentum factor losses in 2021 occurred mostly in periods corresponding to positive inflation surprises. This highlights the strong interaction between sector and macroeconomic risks and their potential impact on the short-term performance of equity risk factors.

The importance of diversification

The main takeaway of this analysis is that the importance of diversification across the six consensus equity factors remains intact, since their risk premium might be driven, over the short-term, by sector or macroeconomic exposures. Investors can smooth out these short-term risks by diversifying across all equity factors. Indeed, a multi-factor strategy with well-balanced exposures to the six rewarded factors is less subject to the underperformance of specific factors or short-lived sector and cyclical exposures.

The benefit of diversification across factors is emphasised here as the strong negative performance of the Momentum factor was more than offset by the performance of the Value, Low Volatility, Size, and Low Investment factors. A complementary approach to diversification is to control directly for sector risks in the construction of multi-factor strategies by using appropriate sector control, such as stock selection within sectors. Nevertheless, over the long term, only good diversification of factor exposure can guarantee the robustness of the outperformance of multi-factor strategies.