Factor behaviours during corrections and recoveries

Fidelity look at using factors to navigate through volatile markets

The S&P 500 Index peaked on February 19, 2020, as the global COVID-19 pandemic became a market reality. The outbreak would end arguably the longest bull market in history, which began after the global financial crisis in 2008.

The combination of a supply shock to the oil market and global supply and demand shocks was unusually severe. What ensued was an extremely sharp correction, with the S&P 500 Index falling by 23.5% (USD) by March 31, 2020, and similar corrections across the globe. Although markets have recovered from their troughs, it is still unclear what the future holds.

During this time, investors have experienced a gamut of emotions, ranging from fear and panic to hope and optimism. It has become clearer than ever that investors need to plan, and not just react. We all know that markets go up and down, that recessions come and go – and that if you have a long-term time horizon, there are ways to achieve strong risk-adjusted returns in all environments. The important questions are, “How is my portfolio positioned to mitigate additional downside risk?” and “How can I position my portfolio to participate in a recovery?”

The study of equity style factors, which include dividend yield, low volatility, quality, value, momentum and size, offers some answers to these questions. Equity style factors have been empirically researched for many years, and have been shown to outperform the broad market over the long term. Allocations to these factors can help provide flexibility and stability in tailoring a portfolio to investors’ specific investment goals.

Factor performance during the drawdown phase

Looking back to 2000, there were six occasions on which the S&P 500 Index experienced a drawdown of 10% or more, including the current correction.

Historically, equity factor performance has varied, depending on the market environment, and because not every correction is the same, and the catalysts may differ.

On average, however, defensive factors such as low volatility, dividend yield and quality have typically outperformed.

(Re)positioning for the recovery

Historically, all the factors participate in the rally as markets rebound, but to differing degrees. Size and value tend to outperform the broad market, in the three, six and twelve months following the trough of the corrections. This is probably because small-cap stocks tend to underperform during a correction but then outperform during the recovery: they carry more risk than large-cap stocks, and therefore tend to benefit when investors’ risk appetite increases. Value stocks, meanwhile, typically include stocks that have become inexpensive or beaten-down, and can then outperform as economic growth turns positive.

Using factors as a tool for portfolio construction

We have a good idea of how equity factors behave in drawdowns and recoveries, but applying this knowledge to portfolio construction is no simple matter. It is very difficult to time the market from peak to trough and trough to recovery, especially with any consistency.

Equity style factors are used most successfully in combination, in a long-term investment plan that captures the potential of all of them. Investors can achieve their investment objectives in a variety of market environments, through opportunistic or strategic exposures to the factors.

Allocations to low volatility, dividend yield and quality factors tend to offer more protection and can be used to position a more defensive portfolio. On the other hand, investors who have a bullish outlook might favour allocations to the value and size factors, which have greater potential for upside participation after a market trough.

But markets can be unpredictable and volatile, especially in the short term. Accordingly, combining multiple style factors will not only add diversification to an investment portfolio but also offer more stable returns over the long term, regardless of what the market is doing.

If you would like to learn more about how factors behave during corrections and recoveries, read our latest whitepaper. For more information, please contact your financial advisor or visit fidelity.ca

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