The TEXPERS Blog

Taking interest rate risk out of factor investing

By Michael Hunstad, Contributor

Interest rate changes and the shape of the yield curve provide a lot of information about market conditions that drive capital allocation decisions throughout the economy and thus influences stock market returns. Interest rates affect stock valuations through two main channels —discount rates that impact the present value of future cash flows and borrowing costs that directly relate to consumer spending. Both influence the performance of equity markets and risk factors to varying degrees.

A lay of the land

To facilitate our analysis, we first place the shape of the yield curve into one of four regimes based on interest rate changes and the shape of the curve:

• Bear Flattening: Interest rates rising, yield curve flattening — typically associated with periods of Federal Reserve tightening and market participants anticipating slower economic growth and inflation.
• Bear Steepening: Interest rates rising, yield curve steepening — typically associated with periods when the Fed is tightening monetary conditions and market participants are anticipating faster economic growth and inflation.
• Bull Flattening: Interest rates falling, yield curve flattening — typically associated with periods of Fed loosening and market participants anticipating slower economic growth and inflation.
• Bull Steepening: Interest rates falling, yield curve steepening — typically associated with periods of Fed loosening and market participants anticipating faster economic growth and inflation.

We emphasize that changes in interest rates do not have any causal relationship to pure factor returns. However, we do see interest rate risks creep into factor portfolios in the form of unintentional sector, industry, leverage, regional and country exposures.

Factor insights during changing rate environments

The following chart summarizes the performance of Fama-French factor portfolios by yield curve regime. The portfolios are constructed without controls for unintentional and uncompensated risks.

Click to enlarge image.

Source: From December 1977 to October 2018 Kenneth French’s website, Northern Trust Quantitative Research. Long/Short portfolio returns constructed using top/bottom decile for the respective factors. Yield curve regimes are based on trailing 6 month yields for the 10 Year and 2 Year treasury.  Empirical duration calculation is based a regression on the change in the level of the yield curve across the 1Y, 2Y, 5Y, 7Y and 10Y tenors with controls for the equity market beta.

Size:  Smaller companies tend to outperform during bear flattening and steepening environments when the Fed is typically tightening and economic growth prospects are improving. 

Value:  Value stocks tend to do the best in bear steepening environments when the Fed is typically tightening and the market is pricing in higher economic growth prospects.

Quality:  High quality companies benefit from a falling rate environment when the Fed is typically easing, as they are able to deploy capital at cheaper borrowing rates to profitable investments.

Low Volatility:  Low volatility stocks tend to do well in a falling rate environment, whereas in a rising rate environment when the Fed is tightening, low volatility stocks tend to underperform.

Momentum: High momentum stocks have tended to do well in most interest rate regimes.

Dividend Yield: Higher yielding stocks tend to do well in a falling rate environment, whereas in a rising rate environment when the Fed is tightening, stocks with higher dividend yield underperform.

A note on low volatility: Low volatility strategies are expected to have some interest rate sensitivity because lower volatility companies generally have stable cash flows, so they tend to finance operations through higher levels of debt, especially in sectors such as utilities and consumer staples. However, employing risk controls to manage sector and other exposures can significantly lower interest rate sensitivity. Many commonly used approaches have little or no risk controls and thus expose investors to a much higher degree of interest rate sensitivity than necessary.

Control the unintended biases

The exposure of factor portfolios to interest rate risk may be intentional, but is more likely to be the by-product of a lack of consideration for this risk. Unintended and uncompensated biases come in many forms including interest rate, sector, industry, region, country and idiosyncratic risks. In other words, they contribute to risk but not return, resulting in inefficient portfolio outcomes. We suggest that investors only take compensated risks and avoid the ones that are not.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of Northern Trust Asset Management or TEXPERS.

Michael Hunstad

About the Author:

Michael Hunstad is the head of Quantitative Strategies at Northern Trust Asset Management. Prior to joining Northern, Hunstad was head of research at Breakwater Capital, a proprietary trading firm and hedge fund. Other roles included head of quantitative asset allocation at Allstate Investments, LLC and quantitative analyst with a long-short equity hedge fund. He holds a doctorate in mathematics, an master's degree in economics and an MBA in quantitative finance.