The stock market run-up investors enjoyed after the fallout in March 2020 came to an end at the beginning of 2022. The US equity market experienced a 12.8% drawdown within the first quarter and ended the quarter down 4.6% as investors digested a hawkish Federal Reserve, higher inflation, and news of the Russia-Ukraine war.1 Strong US GDP and employment data along with coronavirus vaccine distribution and global economic reopening were insufficient to calm investors’ concerns as the Federal Reserve increased interest rates by 25 bps in March and indicated a greater number of rate hikes ahead to combat 40-year high inflation.
Higher dispersion and factor rotation in Q1
Accompanied by elevated risk and uncertainty, equity markets demonstrated higher dispersion and factors had a large rotation, with value stocks outperforming growth stocks by a wide margin. Sixty percent of S&P 500® constituents experienced negative performance, and over one-third ended the quarter down more than 10%, compared to merely 2.3% in the first quarter of 2021. More than 10% of securities ended down more than 20% – while last year only one stock declined during Q1. Energy (+39.0%) and Utilities (+4.8%) were the only positive sectors, making it one of the worst quarters in history.
Many investors took the opportunity to move more money into the equity markets, however. Equity index mutual funds had net inflows of $31 billion in the first quarter, reversing the outflows over the previous three quarters.2 US equity ETFs had net inflows of $82 billion, with $18 billion coming from actively managed equity ETFs. Actively managed equity mutual funds had net outflows of $45 billion, a bit less bleeding relative to the previous three quarters.
In addition to higher stock dispersion, factors also experienced large rotations and dispersion. Using factors to understand the source of risk and return has become standard practice over the last decade. Here we will take a look at factor performance and use the Russell 1000 and Russell 2000 indexes to illustrate their performance gap through a factor lens. One point worth noting and often causing confusion is that factor returns are not directly achievable, as they derive from a long/short portfolio with unit exposure to the target factor and zero exposure to all other factors, also known as a factor mimicking portfolio. Almost all indexes are long only and inherently have exposures to many factors. As a result, the active performance is driven not only by the most obvious characteristic, such as large cap vs. small cap or value vs. growth, but also by other factors. It is useful to take a more nuanced look at all exposures.
A closer look at factor exposures
We use Axioma equity factor risk models in our factor analysis. The factor returns from Axioma’s US equity risk model over the last three years and year to date as of March 31, 2022 show that value has been the best performing factor this year. This continues its trend from 2021, even though it underperformed for a very long time prior to that. High market beta and volatility had a terrible 2021 and continued their underperformance this year after a blockbuster 2020. The growth factor, sometimes associated with high beta and volatility, gave up its performance through the first quarter of 2022. Large capitalization had negative performance YTD and last year, possibly in contrast to the common belief that large cap stocks performed better than small cap stocks. This is exactly where a deeper look into factor exposures helps tell the whole story.
Figure 1 shows the active exposures and active risk decomposition of the Russell 2000 index (R2K) relative to Russell 1000 index (R1K) at the end of Q1, and performance attribution. As expected, the largest active exposure of the R2K is size, which was one standard deviation below the R1K, which contributed 45% of the active variance and +1% of active return. Smaller size helped with performance due to a negative return from the large size factor. The R2K was also overweight value, volatility, market sensitivity, and underweight profitability, with the worst performance detractors being volatility and market sensitivity. As a result, the -2.4% active return and 12% active risk comes from a suite of factors, and while size is one component, other factors also had a significant impact.
In summary, while investors are assessing the uncertainties surrounding higher inflation, rising rates, economic growth, the Russia-Ukraine war, and coronavirus concerns into the next few quarters, it is prudent to take a pulse on the factors driving portfolio performance and risk to really understand what is in indexes and investment portfolios.
Figure 1: Russell 1000 vs. Russell 2000 Index
Source: Axioma Portfolio Analytics. Active return is relative to Russell 1K index for 2022 Q1 and active risk metrics are as of March 31, 2022.
2 Strategic Insights Simfund
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