Managing Your Portfolio in an Extreme Factor Environment

We continue to hope that you and your loved ones remain healthy and safe as we all adopt the new norm of staying sheltered in place.

Today, we’ll summarize some of the key points that we presented on a recent webinar with Qontigo. Specifically, how you can optimize your portfolio to avoid the wild swings endemic to Beta exposure in this environment. We’ll also share our weekly market and factor update.

‍Runaway Beta: How Industry Exposures and Risk Profiles Are Quickly Changing

‍Over the past few weeks, we’ve discussed the massive role that the Market Sensitivity (aka Beta) factor has played during this period of extreme volatility. We began with observations on the return characteristics of the factor relative to what occurred during the Global Financial Crisis, and showed how market sensitivities have become increasingly polarized (Inoculating Against Runaway Beta, 3/15/20). We then followed up by delving into certain sectors and companies to highlight the “runaway Beta” trend (Diving Deeper Into Runaway Beta, 3/22/20).

Here’s how Market Sensitivity has performed since then:

‍Factor Profile: Market Sensitivity YTD (US Medium Horizon Model)

As a reminder, the Axioma US Medium Horizon model uses trailing 1 year daily returns in regression. Here we see that Beta has rebounded significantly on both an absolute and normalized basis since hitting a recent nadir of -12.03% YTD performance on 3/18. Since then, it has rallied back +9.5% and sits at -1.63 SD below the mean.

The evidence is clear that the factor remains incredibly unstable, and exposures to Market Sensitivity have continued to change rapidly. Here’s what has happened at the industry (GICS3 level):

Adding Alpha By Subtracting Beta

‍During the webinar, our colleague Leon Serfaty at Qontigo provided a case study from a client that we share, who runs a US-only long/short, market neutral portfolio. This PM typically had a net exposure between -5% and +5% of NAV, with a target of 0 Beta to the broad market. Earlier in the year and prior to being on the Omega Point platform, they had not been viewing their portfolio through the lens of any factor risk model.

The problem that they quickly discovered was that in this environment, being dollar neutralis NOT the same as being market neutral, which is NOT the same as being factor neutral. In this chart, the PM’s exposure to the market (the Market Sensitivity factor) and predicted beta vs. the STOXX USA 900 started the period close to neutral. As market volatility increased, their exposure to Market Sensitivity continued to move higher, peaking at 0.62 on 3/6.

As the market declined, the PM purposefully lowered gross and net exposure, including reversing exposure to certain industries. For instance, they were net long Specialty Retail by 5.4% on 2/12, and had shifted to become net short that same industry by -5.4% on 3/6. Even so, exposure to Market Sensitivity from the sector increased from 0.015 (basically flat) to 0.2, even as the flip in exposure occurred.

As a result, the portfolio suffered a significant drawdown, primarily driven by performance drag from Market Sensitivity:

Around this time, the PM reached out to Omega Point to help manage this exposure, as they were frustrated that their efforts to remain market neutral had only resulted in losses. We collaborated with them to create a simple optimization where we sought to keep gross and net exposures the same, while reducing drag from Market Sensitivity and other factors.

We ran two flavors of optimizations - one with a 50% change in allocation allowed, and one with an 80% change in allocation allowed. Here are the return and risk results between the base portfolio (AX OP Webinar Manager1) and the two optimized versions for 2/5/20 - 3/18/20:

As you can see, by leveraging the Omega Point optimization, this manager would have been able to improve performance by up to 1.92%, while reducing Total Risk by almost 4%! This manager had positive alpha characteristics throughout the period, so we were simply able to reduce the noise from factors in order to rescue this portfolio.

In this environment, PM’s may need to increase the frequency that they rebalance their portfolios in order to keep up with the changing environment. Please reach out to me if you’d like to discuss how Omega Point can help optimize your portfolio in this same manner, to mitigate the negative impact of unintended factor bets.

US & Global Market Summary

US Market: 3/20/20 - 3/26/20

• The market saw a steep rally for much of the week, driven by investor optimism in the actions taken by the Fed and the $2.2T COVID-19 relief bill that was officially signed into law on Friday. The major indices closed lower on Friday (not captured in above chart), but maintained the double digit gains made over the week (the S&P 500 ended the week +10.2%, its best week since 2009). A late downturn On Friday coincided with news that the Fed would begin reducing its pace of Treasury buying to $60B starting next week.
• On Thursday, jobless claims topped 3.3 million, shattering the previous weekly record of 695,000 in 1982. The market shrugged this number off despite it being even worse than consensus forecasting.
• The week also saw the US surpass 100,000 positive COVID-19 tests, the highest number of cases worldwide.
• U.S. consumer sentiment dropped to a 3.5 year low in March, according to U Michigan, falling the most since October 2008.
• Meanwhile, discussion continues around a potential new OPEC+ deal to calm the oil markets, with the existing OPEC agreement expiring on March 31.

Factor Update: Axioma US Equity Risk Model (AXUS4-MH)

• Earlier, we showed how Market Sensitivity had seen massive positive return in the past week.
• Profitability, which had vaulted +3.59 standard deviations last week, hit a peak of +6.47 standard deviations above the mean on 3/20 and has since started to revert, now sitting at +5.62 SD above the mean.

• Volatility continued to enjoy a recovery on a normalized basis - moving up 0.62 SD while exiting Oversold territory.
• Value, the focus of our discussion a few weeks ago, saw some strength as it tries to claws its way out of Extremely Oversold space.
• After a couple of weeks of substantial outperformance, Size fell from a peak of +3.2 SD above the mean on 3/18 to +2.58 SD above the mean, still in Extremely Overbought territory.
• Growth saw some respite after being in virtual freefall over the past month, bouncing from -2.25 SD below the mean on 3/23 and starting to show signs of recovery.
• US Total Risk (using the Russell 3000 as proxy) increased by over 5%, and now sits at nearly 33%.

Factor Update: Axioma Worldwide Equity Risk Model (AXWW4-MH)

• Exchange Rate Sensitivity, which measures a stock’s sensitivity to a basket containing USD, EUR, GBP, JPY saw a massive decline, falling over 3 standard deviations in 3 days after news of bipartisan agreement on the $2T stimulus bill was announced on Monday, March 23rd. We’ll dive deeper into this factor in our next week’s post.

• Meanwhile, Market Sensitivity enjoyed a nearly +1 SD move, now sitting at -2.26 SD below the mean (still Extremely Oversold).
• Unlike the US, Profitability continued to see strength as it nears almost +4 SD above the mean.
• Size worldwide also didn’t experience the weakness that it saw in the US this week, and now sits at over 4 standard deviations above the mean.
• Value lost its Extremely Oversold designation as it climbed +0.72 SD in a week, now sitting at -1.72 SD below the mean.
• Growth continued to decline, now sitting at the cusp of an Extremely Oversold label at -1.94 SD below the mean.
• Global Risk (using the ACWI as proxy) rose 4.82% and ended the week at 30.6%.

Regards,
Omer