Road to Stock Market Rebound Was Rocky

When Markets Are Recovering, Don't Ignore Volatility

3 Lessons From 2020

Expect Economic Recovery in 2021 to be Robust

Capturing the Ups and Downs in Coronavirus Equity Markets

Image by ChristianChan from iStock.

By KENT HARGIS, SAMMY SUZUKI & JILLIAN GELIEBTER/Alliance Bernstein

Several equity factors diverged significantly from their typical performance patterns during the COVID-19 crisis. By understanding how factor returns behaved in this market correction relative to their historic norms, investors can not only prepare for future volatility but also take advantage of short-term market dislocations.

Challenges to Safety Stocks

Factors, groups of stocks that target specific drivers of return across an index or market, had startling performance results during the coronavirus market disruption. Minimum Volatility (Min Vol) stocks outperformed the MSCI World Index in the sell-off though their downside protection was not as strong as usual, and their upside capture was lower than expected in the subsequent market rally. Value stocks fell further than expected and then failed to outperform during the rebound—as they typically do.

WHAT IT MEANS: The MSCI World Index is a broad global equity index that represents large and mid-cap equity performance across all 23 developed markets countries.

But Growth stocks delivered the most surprising results. This was the only factor to protect much better than expected during the downturn, and then also outperform in the bounce off the bottom.

Investors can evaluate these patterns by looking at upside/downside capture. Upside capture measures how much the factor increased relative to a rising broad market. Downside capture measures how much the factor declines relative to the falling market.

By combining these measures—upside capture minus downside capture—we can evaluate total market capture as a spread. A positive spread means the factor collects more good times than bad times, which may lead to outperformance over time. Likewise, a negative spread means the factor accumulates more bad times than good, a result that often leads to underperformance.

Comparing the spread between the upside/downside capture ratio this year to historic norms shows just how different recent performance patterns have been.

For both Min Vol and Value, the upside/downside capture spread was roughly 30% worse than average. For Min Vol stocks, the performance during the downturn was particularly surprising, as these stocks usually provide protection in a falling market. In contrast, Growth stocks posted a positive spread of 29% over average.

Click chart to enlarge.

Unusual Circumstances Create Unusual Opportunities

COVID-19 shutdowns created an unconventional cause for the correction and may have played a hand in the unlikely sector performance results.

This time around, investors didn’t flock to the traditional relative safety of low-volatility sectors like utilities and real estate during the sell-off. Instead, they congregated in growth companies like online retail, at-home media and technology hardware and equipment—industries that benefited from the health crisis and lockdowns. The performance of the industries, both favored and slighted, contributed to the uncharacteristic upside/downside captures for the factors shown above.

No Norm Here, New or Not

Will these patterns be the new norm? Too hard to say. But the distortions may provide opportunities for investors to rebalance portfolios. Since 2013, Min Vol stocks have not been this cheap, and Growth has not been more expensive.

However, not all Growth stocks are created or valued equally. There are a wide variety of growth businesses with wildly differing valuations, so selectivity is key. And quality defensive investments currently offer some of the best risk-adjusted return potential, in our view.

The world remains an uncertain place. COVID-19 cases continue to increase, US-China tensions are high, economic ambiguity persists, not to mention the upcoming US election. Over the long term, we believe a dynamic defensive strategy can help fuel an offense during volatile market episodes.

The types of stocks that provide protection in a crisis are always changing. By finding select high-quality defensive stocks for a given crisis at reasonable prices, investors can reduce losses in a sell-off, which makes it easier to recover when markets rebound.

Alliance Bernstein is an Associate Member of TEXPERS.The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams or TEXPERS and are subject to revision over time. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein.

About the Authors: 

Kent Hargis, Co-chief Investment Officer, Strategi Core Equities

Kent Hargis was promoted to Co-Chief Investment Officer of Strategic Core Equities at AB in 2018. He has been managing the Global, International and US portfolios since their inception in September 2011, and the Emerging Markets Strategic Core portfolio since January 2015. Hargis was named Head of Quantitative Research for Equities in 2009, with responsibility for overseeing the research and application of risk and return models across the firm’s equity portfolios. He joined the firm in October 2003 as a senior quantitative strategist. 

Sammy Suzuki, CFA, Co-chief Investment Officer, Strategi Core Equities

Sammy Suzuki was promoted to Co-Chief Investment Officer of Strategic Core Equities in 2018. He has been managing the Emerging Markets Strategic Core portfolio since its inception in July 2012, and the global, international and US portfolios since 2015. Suzuki has managed portfolios for well over a decade. From 2010 to 2012, he also held the role of director of Fundamental Value Research, where he managed 50 fundamental analysts globally. Prior to managing portfolios, Suzuki spent a decade as a research analyst. He joined AB in 1994 as a research associate covering the capital equipment industry, and then became an analyst covering the technology industry. 

Jillian Geliebter, CAIA, Director, Equities

Jillian Geliebter is a Director of AB’s Equities business. In this role, she works with the firm’s research and portfolio-management teams, as well as with clients around the world. Previously, Geliebter was a senior RFP writer for AB’s Equities services. She has been with the firm since 2009.

BY PHIL DESANTIS, Westwood Holdings Group

As a high-performing equity market environment lifted most stocks over the last decade, the value proposition for active management in efficient asset classes such as U.S. Large Cap has been scrutinized by both institutional and retail investors alike.

Low active share, otherwise known as “closet indexing,” high turnover and lofty management fees all contributed to a trend of marginal performance results for active products relative to benchmarks. In response, many investors have chosen to reduce their allocations to active managers and increase passive holdings, particularly in efficient asset classes.

During this period of dominance by passive products, the relationship between asset owners and investment managers has transformed, increasing fee pressures to improve alignment over existing fee structures. While overall fees have come down over the last decade, the industry has done very little to truly level the playing field for investors and solve the real problem — aligning fees to the value of active management and improving the probability of a favorable outcome depending on manager skill and the efficiency of the asset class.

Mutual fund investors paid a staggering $100 billion dollars in expenses to underperforming asset managers over the last ten calendar years.

We believe the industry is primed for a major disruption that will better reflect the value- added returns of active management by solving the fee problem, altering the probability of winning for investors, and in turn radically changing asset allocation decisions.

Read more in our whitepaper, “Mission Possible: Changing the Probability of Winning for Active Investors.”
The views expressed herein do not constitute research, investment advice or trade recommendations, do not necessarily represent the views of Westwood Holdings Group nor TEXPERS, and are subject to revision over time.

About the Author:

BY NICK YEO, Aberdeen Standard Investments

It’s an odd time to talk up Chinese stocks. China is locked in a bitter trade war with the U.S. and it was the world’s worst-performing major market last year.

It's an inefficient market 

Retail mom-and-pop investors account for 80% of trading turnover on the country’s stock exchanges, which, until recently, were closed to overseas investment. They tend to be swayed by breaking news rather than cool-headed analysis of company prospects. The result is a volatile, sentiment-driven market.

But this creates opportunities for investors to pick up good companies trading below fair value. Sentiment can change quickly. Two drivers that could inspire a turnaround are a U.S.-China trade deal and China’s inclusion in global indices.

A prolonged trade conflict would hurt corporate profitability. Tariffs dent the earnings of companies that benefit from global supply chains, many of which are listed on U.S. exchanges. This may have been a factor behind last December’s S&P 500 Index slump.

It’s in the interest of both sides to resolve this dispute. The catalyst could be another market rout. President Trump is already risking backlash from rural Republicans impacted by Chinese duties.

While we expect talks to continue, we’re confident a deal will be struck — especially with a U.S. presidential election on the horizon. Any deal would likely be received positively by markets, giving companies greater clarity on their revenue prospects and spending plans.

At the same time, global index provider MSCI is doubling the number of Chinese stocks — or A-shares — in its emerging-markets index. Within five years, it’s estimated they could account for 20%. This would draw in capital from foreign institutions that track the index passively.

This is long-term money, stickier than today’s sentiment-driven flows. It will expose Chinese company managements to global standards of accountability and best practice.

Improving governance tends to enhance corporate performance and helps to realize value for shareholders. We believe it’s better for investors to get ahead of this curve.

Back to the future

So why invest in China? The answer is growth. Despite frequent bulletins on China’s slowing GDP growth, it is still above 6% a year — faster than advanced economies.

At the start of this year, consensus 2019 earnings forecasts for A-share stood at 15%. Investors will struggle to find many markets offering double-digit growth.

Perspective is important. China and India used to account for half of global GDP growth, before the industrial revolution gripped the U.S. and Western Europe in the 18th century and reduced both to a statistical irrelevance.

It was only in 1978 that Communist Party reformists set in motion a process of industrialization and urbanization on an unprecedented scale. China is now the world’s second-largest economy in nominal terms.

Within 30 years, China and India are again forecasted to account for 50% of global GDP growth. It points to the mother of all mean reversions.

Today 60% of China’s population lives in urban areas — and this figure is rising. People gravitate toward cities to find better jobs, health care and education services. It means they get wealthier, too. In 1960, China’s GDP per capita was $100. Today it’s $7,500, and in Shanghai it’s $20,000.

Some 39% of the population is classified as middle class now — from 2% in 1999. That’s half a billion consumers. Life expectancy has also more than doubled since 1960, to 76 years.

Rising wealth and living standards mean China is moving to higher-value goods and services. Investors can buy into listed companies poised to benefit from this structural growth. We have found quality stocks in areas including travel, food and beverages, luxury goods and Chinese medicine.

China’s exchanges also have low correlation to global markets. Chinese policymakers are steering the economy away from manufacturing and exports to reliance on domestic consumption and services. The latter make up more than half of China’s GDP growth today.

Domestically focused firms are less tied to global-economic and interest-rate cycles. They are also more insulated from the worst effects of the trade war. In this way, A-shares can bring valuable diversification benefits to a portfolio.

So investors prepared to look beyond today’s trade war and focus on the long-term opportunity will be well placed to ride on China’s future consumption growth.

Important information

Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries. Diversification does not ensure a profit or protect against a loss in a declining market.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of Aberdeen Standard Investments or TEXPERS.

About the Author
Nicholas Yeo is the director and head of the China/Hong Kong Equities team at Aberdeen Standard Investments. Yeo holds a bachelor's degree in Accounting and Finance from The University of Manchester and a master's degree in Financial Mathematics from Warwick Business School. He is a CFA charterholder.

Assessing the Merits of 

long-only equity allocations

By Marlena Lee, guest columnist

Investors continue to search for effective ways to structure their long-only equity allocations.

Many passive approaches have offered diversified exposure at low management fees with a minimal governance burden. However, concerns about the potential for a sustained period of lower returns have prompted some investors to revisit their decision to index and contemplate adding factors to their portfolios. Assessing the merits (and limitations) of any “factor-based” approach requires asking some seemingly fundamental but important questions:

• Why should there be differences in expected returns across stocks? The chance that all stocks have the exact same expected return is virtually zero. There is a multitude of reasons why different stocks should have different expected returns, such as differences in risk or differences in investor preferences.
• How can you identify these differences in expected returns? A good rule is that investors should not rely solely on back-tested results. There is a saying in statistics – if you torture the data long enough, it will confess to anything. A sound theoretical and empirical framework reduces the chance that a coincidental pattern in historical stock data will affect our conclusions.Valuation theory suggests the price of a stock depends on a few variables. One is what the company owns minus what it owes (book value). Another is what investors expect to receive from holding the stock (expected profits) and the discount rate they apply to those expectations (the investor’s expected return). This framework provides very useful insights. One insight is that the expected return investors demand for holding a stock drives its price. Another is that combining price with book value and expected profits allows us to identify differences in expected returns across stocks. For a given level of expected future profits, the lower the price, the higher the discount rate. For a given price, the higher the expected future profits, the higher the discount rate. Empirical analysis is also important – it can help inform expectations about the magnitude of premiums and build confidence that the premiums we see in the historical data are not there by chance. There are numerous studies documenting size, value, and profitability premiums using many different empirical techniques on large data sets—90 years of US data, 40 years of non-US developed markets data, and 30 years of emerging markets data. If we can expect premiums and have a good way of identifying them, we still need to assess how best to capture them.
• How confident are you that premiums can be captured? What are the risks? If the premiums can be pursued in a well-diversified strategy, this improves the likelihood they can be captured by investors. Why? If results are driven by a small group of stocks or a small percentage of market cap, it is more likely to be a chance result. Additionally, less diversified strategies pursuing premiums are likely to have higher turnover and higher costs.  

Our experience is that using current market prices is important in identifying and capturing premiums. Combining current prices with company fundamentals creates an instantaneous snapshot of differences in expected returns. At that specific instance in time, stocks with lower relative prices and/or higher profitability have higher expected returns. If there is a spread in relative prices at any point in time, we should expect a value premium. This implies we can use current prices to continually focus on higher expected returns.

This does not mean that higher expected returns will be realized continuously, or even consistently.  For example, it is not unprecedented to see value stocks trail growth stocks over a 10-year period. A period of underperformance like this, however, is not by itself compelling evidence that one should no longer expect a value premium in the future. While there is a non-zero probability that any realized premium can be negative over any given investment horizon, that probability decreases over longer investment horizons.

While we encourage a long-term focus, we acknowledge that doesn’t make any underperformance over the short term less disappointing. Asset owners must be willing to accept that uncertainty as part of investing in premiums, just as they do investing in equities. Asset managers can help by not adding to that uncertainty through chasing chance results or inefficiently targeting premiums.

We believe a strong partnership with clearly set expectations, a long-term focus and expertise in implementation can translate to better outcomes for intermediaries and, ultimately, plan participants.

Dimensional Fund Advisors LP, an investment advisor registered with the Securities and Exchange Commission, receives fees for investment management services provided to client members of TEXPERS. There is no guarantee of strategy success. This information should not be construed as investment advice.

About the Author

Marlena Lee

Marlena Lee is co-head of research and vice president at Dimensional Fund Advisors in Austin. As co-head of research, Lee helps manage the firm's general research efforts. She shapes the research agenda by working with clients and the Sales and Investment teams to identify research topics on a variety of investment-related matters that may be useful to clients, including asset pricing, asset allocation, and retirement. Lee is also a member of the Investment Research Committee. Prior to joining Dimensional, she worked as a teaching assistant for Nobel laureate Eugene Fama, a professor at the University of Chicago Booth School of Business. Lee earned her doctorate in finance and a master's degree from the Chicago Booth School of Business. She also holds a Master of Science in agricultural and resource economics and a Bachelor of Science in managerial economics from the University of California, Davis.