Factor Spotlight 2024 H1 in Review

Extreme Movers Analysis

Background / Definitions

2007 - Present: Classifying “Factor-Driven” and “Alpha-Driven” Markets
This analysis will focus on the US market using our US Extreme Movers Portfolio. The portfolio is a weekly-rebalanced, market-neutral portfolio that invests long in the top decile of best performers and shorts the bottom decile of performers in the Russell 1000 index. The characteristics and performance of the Extreme Movers Portfolio point to the areas of the market that were in and out of favor and provide valuable insight into themes that drove stock returns.

Our US Extreme Movers portfolio began on Jan 1, 2007. Each week, we observe performance decomposition through the lens of various risk models and use quintiles to categorize the performance on a spectrum of the most “Alpha-Driven” weeks to the most “Factor-Driven” weeks. To calibrate our classification, we took the total sample of all weeks (>910) since Jan 1, 2007, and ranked them by Alpha Contribution to return percentage.

A Very Alpha-Driven Week (Top Quintile) is one where an Alpha Contribution to return is HIGH and a Very Factor-Driven Week (Bottom Quintile) is one where Alpha Contribution to return is LOW.

Below are the Alpha Contribution thresholds that define the quintiles:

In addition to understanding what portion of the market volatility was attributable to factors and alpha, we also need to proxy the market volatility levels. We applied the same ranking methodology to categorize the volatility of weekly periods based on the total return of the US Extreme Movers portfolio. We categorized these quintiles from “Very Volatile” to “Very Calm.”

To break down the historical context, we segmented the historical data by calendar year and market regime to give investors a sense of how the recent and current market stack up against prior periods. Details on the thematic market regimes are below.

Aggregating Weeks into “Alpha-Driven” vs. “Factor-Driven” Periods

Alpha availability is always crucial for fundamental investors, but not all periods in history have seen the majority of market volatility being attributable to stock-specific nuances. Periods with higher availability of alpha provide more opportunity for stock-pickers’ competitive advantage to shine, while periods clouded by market factors tend to restrict the fundamental investor’s ability to drive idiosyncratic returns. Here, we’ve broken down each week since 2007 according to our spectrum of “Very Factor-Driven” to “Very Alpha-Driven” and examined the percentage of weeks in each category.

We found 54% of the weeks in 2024 H1 were at least “Alpha-Driven,” and 23% of the weeks were “Very Alpha-Driven”. This exceeds what was seen in 2023 by almost 60%, and so far is the highest percentage observed since 2014. Conversely, only 8% of the weeks in 2024 H1 were “Very Factor-Driven,” which is almost half of what was seen in 2023 and aligns with levels from the post-GFC era between 2010 and 2014. This indicates that bottoms-up, fundamental stock-pickers were very well positioned these past six months to uncover stocks whose performance was not highly-influenced by market and macroeconomic forces.

When comparing to market regimes, we can see that 2024 H1 presented significantly more alpha opportunity than any other period. The “Post-GFC + Pre COVID” era was the closest comparison with 48% of at least “Alpha-Driven” weeks, though 2024 H1 skewed more towards the “Neutral” and “Factor-Driven” categories and less towards “Very-Factor Driven”.

Aggregating Weeks Into Volatile vs. Calm Periods

Another key area we looked at was the overall level of volatility observed in the Extreme Movers portfolio over the past six months relative to previous periods. The charts below aggregate each week since 2007 on a scale from "Very Calm" to "Very Volatile," across calendar years and market regimes.

We found that 35% of weeks in 2024 H1 were "Volatile", along with an additional 31% of weeks that were "Very Volatile". This was very similar to what we saw in 2023 and almost aligns with the levels of volatility seen in 2020. There were an additional 24% of "Very Volatile" weeks, reaching an aggregate level of 69% that has only been exceeded in 4 out of the last 17 years. In contrast to 2023, 2024 H1 has seen slightly more periods of calm, with 8% of periods being "Calm" and 4% being "Very Calm". The percentage of calm and very calm periods most closely aligned with 2020 and 2022.

When looking at past regimes, the overall distribution of volatility in 2024 H1 was quite similar to that observed during COVID, indicating that market volatility has still been relatively high this year compared to the historical average.

Elevated Volatility with Factor Influence

To round out our analysis of the US Extreme Movers portfolio, we focused in on the cross-section between periods that have been both factor-driven and volatile over the past six months. In other words, "how often was the US market heavily volatile because of factors?" The intersection of these two categories represent a challenging environment for fundamental investors, where stock prices are experiencing significant price movements, but not due to alpha.

The chart below presents the percentage of weeks each year categorized as at least "Factor-Driven" and at least "Volatile." When framed in this context, we can see that 2024 H1 has been significantly less volatile than 2023, with no periods that were both "Very Volatile" and “Very Factor-Driven”. That said, there were 19% of weeks that ranked “Volatile” and “Factor-Driven”, which was roughly on par with 2009, 2021, and 2023. The percent of factor risky weeks in 2024 H1 was also significantly lower than that of any previous regimes.

Market Concentration

The Magnificent 7

The “Magnificent 7” stocks (Apple, Alphabet, Microsoft, Amazon, Meta, NVDIA, and Tesla) have led the AI-driven trade into 2024; their strong performances increasing what was already a hefty share of the US market. Through the first half of 2024, the Mag 7 accounted for almost two thirds of the S&P 500’s total return (~9% of ~15%).

The market share has ballooned post-COVID and H1 2024 showed its sharpest increase. As of the beginning of 2016, the Mag 7 accounted for an aggregate 13% weight in the S&P 500. As of the end of 2021, it was 34% and, by end of June 2024, it reached 46%. Nearly half of the US large cap stock market is constituted by seven companies. Of the forecasted risk of the S&P, they accounted for over 32% as of June 28th which means they’re projected to represent roughly one third of the index’s future volatility.

Effective Number of Stocks

With the growing influence of the largest stocks in the US market, broad-based indices, which were formerly a fair representation of hundreds or thousands of stocks, now behave like far smaller selections. To illustrate the continued trend, we calculated the “effective number of stocks” using the Herfindahl-Hirschman Index for the S&P 500, Russell 1000, and Russell 3000 indices. As of May 2016, the Russell 3000 had an effective number of 215 stocks which means the index behaved like a market of 215 equally-sized stocks. As of the end of June 2024, that has declined all the way to 65. Over that same time period, the S&P 500 has gone from an effective number of 148 down to 50.

The “Market” is Idiosyncratic?

As a result, the “market”, represented below by the S&P 500, has become increasingly idiosyncratic in nature. Because indices have historically been broadly diversified, nearly all of the risk and performance was explainable through common systematic factors in risk models. At the beginning of 2016, only 0.5% of the S&P 500’s risk was defined as idiosyncratic or “stock-specific”. As of June 28th, 7% of its risk is idiosyncratic.

The Momentum Rally

The first half of 2024 has been a particularly strong period for US Momentum factors. The winners of 2023 have continued to outperform and outperform to a strong degree. Popular stocks that are connected to AI have led the way and a persistent inflationary environment provided little reason for the trend to stall or reverse (though we might be seeing a shift in mid-July).

Consumers and Industrials were the two sectors within which Momentum rallied most. Relative to their predicted volatilities as of 2023 year-end, both sectors showed greater than three standard deviation moves. Although all sectors were positive through the first six months, the HealthCare sector lagged on Momentum through late May and the performance within Financials was notably muted relative to the rest of the market.

Cumulative Return, Volatility, and Sharpe Ratio (H1 2024)

Managers that entered 2024 with positive Momentum exposure likely saw that exposure naturally grow substantially through the first six months as they held onto key Momentum winners. The most significant one month Momentum reversal, which came in 2009 following the GFC downturn, saw Momentum factors across risk models fall by two to four standard deviations. To put that into context, Barra’s US Momentum factor in their Long-Term model has a one month predicted volatility of 1.58%. For a portfolio that has an exposure of 1, a two standard deviation downward move in Momentum over the next month would result in a -316 bp impact and a four standard deviation move would result in a -632 bp impact.

If you have any questions or would like to evaluate your portfolio in Omega Point, don’t hesitate to reach out.

Regards,
Reshma