Did Factor Investing Continue to Diversify in 2022?

Background – Quoniam’s research findings

In our recent publication “Diversifying credit portfolios with factor investing”, we showed the diversifying effect of credit factor investing in a broad IG credit allocation. The main findings of our study are:

• The performance of systematic factor strategies is much less dependent on the market direction; fundamentally managed funds tend to outperform in periods of fallings spreads and underperform when market spreads rise
• The correlation between fundamental and systematic strategies is low, while the correlation between different fundamentally managed strategies is high; diversification benefits are best captured by mixing fundamental and systematic strategies
• Fundamental strategies have lower factor exposures than systematic strategies except for carry to which fundamentally managed portfolios are strongly exposed

These findings indicate strong diversification benefits for investors by combining systematic und fundamentally managed IG credit strategies.

Market moves in 2022 were extreme

The investigation period of our previous study ended in mid-2021. Since then, a lot has happened on the market:

• Central banks started their rate hike cycles with the Fed increasing the Fed funds rate by 225 basis points from 0.25% to 2.5% while the ECB followed with 125 basis points from 0% to 1.25% (and the deposit rate from -0.5% to 0.75%)
• Interest rates have risen relentlessly with ten-year US rates climbing from 1.59% to currently 3.44% and two-year rates rising more than 27-fold from 0.14% to 3.85%; for Europe the increases are of similar magnitude with ten-year Bunds rising from -0.19% to 1.74% and the two-year Schatz yield climbing from -0.66% to 1.51%
• Credit spread also rose considerably since end of May 2021 increasing by 56 basis points for US IG credit to 1.4% and by 115 basis point for Euro IG credit to 2%
• These moves were also accompanied by strong currency movements with the Euro falling from 1.22 USD/EUR to parity

Did systematic investing continue to diversify?

Given the exceptional nature of the market moves in 2022, investors needed diversifying approaches to their portfolios. Therefore, the period following the completion of our study are an ideal litmus test for the diversification benefits a systematic approach can provide to investors. Did systematic factor strategies work in the extreme market environment of 2022?

To answer this question, we compare the performance results of the systematic strategy with those of the ten best-performing funds in each of the Euro IG and global IG credit strategies. We choose the best-performing funds as an out-of-sample test of their properties and as the most likely peer group an investor would have picked prior to the start of the new investigation period. We look at how both the systematic and the fundamentally managed portfolios fared in the market environments over the thirteen months from 06/2021 to 06/2022, how their performance relate to the spread movements on the market and how differently the alphas of both strategies behaved.

Results

The following graphs show the relationship between market spread changes and fund alphas for Euro IG and global IG, respectively. In both graphs, the systematic factor strategy and the peer group of the ten best fundamentally managed funds over the previous five years are shown.

Figure 1: Market spread changes and fund alphas 06/2021 to 06/2022

The most interesting insights of this analysis are as follows:

• The performance of the ten best-performing funds over the previous five years is negative with average monthly alphas of -0.41% and -0.1% for global IG and Euro IG, respectively, significantly below the multi-factor strategy; it shows that over the last twelve months past performance was not a good indicator of future performance
• The trend line in the two graphs is steeper by a factor of 7 to 8 for the fundamentally managed credit strategy than for the systematic strategy; that means, that one basis points spread increase on the market will lead, on average to a seven- to eight-time larger underperformance of the fundamentally managed strategies compared to the systematic strategy

What is the correlation between the fundamentally managed and the systematic credit strategies? The following graphs show the relationships.

As in the original study, there is a slight positive relationship between the alphas of the systematic and the fundamental strategies but the trendline is relatively flat. Again, the steepness is somewhat stronger for Euro IG than for global IG. This similarity with the original findings indicates that the market environment of 2022 did not challenge the differences in characteristics between the two approaches.

Conclusion

The first half of 2022 was challenging for investors, but it provides a good test ground whether accepted fund characteristics, performance patterns and risk behaviour are robust to different market environments. If a relationship that held in normal markets continues to be present on the market in the volatile months of 2022, we can assume that it is a general relationship in the market.

We extend our investigation of the diversification benefits of multi-factor credit strategies into 2022 and find the following results:

• Systematic credit strategies continue to be much less dependent on the direction of the market than fundamental credit funds
• There continues to be only a slight positive relationship between the alphas of these two strategies
• The best-performing funds over the period 2016/6 to 2021/5 underperformed considerably during 2021/6 to 2022/6

The different risk characteristics of fundamentally managed and systematic credit strategies seem to be robust in different market environments. This should give investors confidence that the combination of the two investment strategies helps them to systematically reduce risk and stabilise their performance.