Maximizing Alpha in Stressful Environments

Throughout history we have observed that in rising interest rate environments, cyclicals tend to lose while defensives tend to gain— and it’s happening again amid the rate hikes of 2022 - 2023. To analyze this phenomenon, we created a defensive and a cyclical variant of the S&P 500 Equal Weighted Index.

S&P 500 Defensives Equal Weighted index:

• Healthcare

• Utilities

• Consumer Staples

• Energy

S&P 500 Cyclicals Equal Weighted index:

• Utilities and Telecom

• Materials

• Consumer Discretionary

• Financial

• Information Technology

• Industrials

Unsurprisingly, the hypothetical defensive portfolio outperformed the hypothetical cyclical portfolio throughout the past 12 months, as well as the S&P 500. Defensives lost 4% while cyclicals lost 12.08%.

Using the FactSet Global Equity Model (Medium Horizon) we can try to understand what contributed to these market returns. The compounded factor return over the past 12 months was led by the following industries: Energy and Equipment, Oil and Gas and Aerospace and Defense in the United States. In addition, the model attributed returns to fundamental style factors such as profitability, book to price, and dividend yield.

Source: FactSet

During previous Federal Reserve rate hikes, from December 2017 to December 2018 (when interest rates went up from 1.25 to 2.5), defensives performed better than cyclicals. However, the trajectory of rate hikes during this period was not as steep and abrupt as the current interest rate environment, thus reducing the loss of the cyclicals hypothetical portofolio (-8.3%) and magnifying that of defensives portfolio (-6.13%).

Source: FactSet

Around this time, our risk model shows that market returns were driven by sectors like Health and Biotech, and style factors like profitability, book to price and dividend yield. These observations demonstrate two themes:

• When capital markets are in turmoil, the hypothetical defensives portfolio tends to outperform cyclicals

• Stocks with stronger profit margins, higher book to price ratios, and higher dividend yields positively contribute to returns

Source: FactSet

Was this predictable?

We can use a stress test scenario to understand if the risk model could predict what style factors and sectors would perform well should there be a Federal Reserve rate hike of 4.5% distributed over 12 months. For this example, we have chosen an event weighted stress test, which assigns higher weights to dates closest to the occurrence of such implied rate hikes, while calculating the impact on stock and factor returns.

The FactSet Global Equity (Medium Horizon) model projected the cyclicals hypothetical portfolio would have lost much more than defensives in such a scenario. It forecasted the Information Technology Sector would lead this downfall, which is the sector that was hit the hardest over the past 12 months. The current banking turmoil further supports this hypothesis.

Source: FactSet

Source: FactSet

Catch Lightning in a Bottle

Given the unpredictable environment, we created a portfolio that only purchased from the defensive hypothetical portfolio, while skewing towards attributes like high profitability, dividend growth and book to price. The objective is to maximize returns with a signal containing a composite of historical returns over three years, where the recent one-week return is given the highest weight. The profitability, dividend growth and book to price attributes used are from FactSet’s Quant Factor Library (QFL) which is a library of clean, validated factor values. We have also added a constraint to maintain maximum weight per security at 1% to improve diversification. This simulated portfolio is rebalanced weekly starting in March 2022.

Results

Our simulated portfolio managed to beat the hypothetical defensives portfolio, the S&P 500, and cyclicals. It closely tracked the defensives but with less downside (-2.87% vs the -4% we saw previously). Its predicted tracking error vs a USD cash portfolio stood at +/-18.37%. This active risk is a gauge of how much the portfolio stands to lose or gain over a period of one year from now, which is lower than cyclicals and the S&P 500. The same portfolio also has a 1% probability of losing 2.24% on any given day, compared to the cyclicals hypothetical portfolio which has a loss potential of 2.64%.

In conclusion, this type of analysis can be done to understand if history stands to repeat itself, how we are positioned for a stressed market scenario, and how can we be smarter about systematically tilting towards anticipated factor trends.

Source: FactSet

Source: FactSet

This blog post is for informational purposes only. The information contained in this blog post is not legal, tax, or investment advice. FactSet does not endorse or recommend any investments and assumes no liability for any consequence relating directly or indirectly to any action or inaction taken based on the information contained in this article.