EC Has The Recent Surge In US Equity Factor Correlations Peaked?

Looking for robust diversification opportunities in equity risk factors has turned up modest and sometimes disappointing results in recent years in broad-brush terms and it’s only gotten worse in the pandemic. The question is whether the worst has passed? Possibly, although the outlook remains cautious at best. Let’s dig into the numbers for some details.

Recall that the goal is to decompose broad stock market beta into several flavors of the risk premia that, in the aggregate, capture the overall footprint of the asset class while dispensing lower risk, higher return or some combination of both vs. holding, say, the S&P 500 Index. By rebalancing the mix, it’s possible to exploit the natural ebb and flow of factors so that 1+1=3. That, at least, is the theory. Not surprising, it’s a tall order and putting it into practice and reaping substantial benefits is no mean feat.

To be fair, some slices of the various equity factors do outperform the broad market in absolute and risk-adjusted terms. But there’s also plenty of underperformers. Overall, it tends to be a wash and so simply holding everything and rebalancing back to a quasi-market weights probably won’t provide much value-added performance and/or risk reduction. You’ll almost certainly need to do more.

That leads to the main event: Which equity factors do you favor, which ones do you pan, and when? Like any attempt at deconstructing a broadly defined beta footprint and timing the choices, the answers are warm and fuzzy in real time.

“A multi-factor strategy is placing a lot of bets,” says Josh Russell, an analyst at Franklin Templeton Investment Solutions. “If all of these collapse into one unidirectional bet, you really lose your edge.”

The Bloomberg article that quotes Russell also presents data that shows that equity factor strategies “are failing to live up to their diversification label in an era when recession-spurring lockdowns, rally-inducing stimulus and game-changing vaccines are all moving markets.” The smoking gun: “Factor correlations have risen to the highest in at least two decades.”

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