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

On this basis, the opportunities look more encouraging. Indeed, the lowest correlation for the five-year window falls to just 0.27, once again for momentum (MTUM) and small-cap value (IJS).

It’s fair to say that it’s still premature to dismiss the idea that building an equity portfolio with factor building blocks has run out of road. As the numbers above suggest, the opportunities may fading and in short supply, but (at the risk of testing your tolerance for metaphor) the well has yet to run dry in this corner.

Nonetheless, the marketplace of equity factors is relatively efficient (most of the time) and so the best results on this front will likely deliver modest advantages over the broad market. There are just too many investors fishing in this lake (there I go again) to expect blowout results after adjusting for risk. But if you’re willing to put in the work and tolerate the not-trivial possibility of high tracking error vs. the market overall, you can find some degree of pay dirt (sorry) here. But be warned: your odds of success, which were never particularly higher in the best of circumstances, have slumped recently.

The good news: correlations aren’t static and what goes up tends to come down and it appears that the recent surge is pulling back. For some factor pairs, the potential diversification payoff could be substantial in 2021 and beyond. But it’s hardly a free lunch since the price tag for earning market-beating results is directly related to how far you’re willing to deviate from the standard equity market portfolio? For the average investor, it’s not an enticing proposition. That leads to the standard question: Are you average? If not, what does that imply? One possibility: customize your equity factor allocation.

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