factor building blocks

Factor Behaviour During the Pandemic

New Paper Analyses Factor Volatility

A new academic paper finds some investment factors coped better with market volatility during the onset of the coronavirus pandemic than others

As the full extent of the coronavirus pandemic became clear towards the end of February 2020, markets across the world took a dive, resulting in some of the sharpest falls on record.

But only a month later, markets began to recover on the back of optimism about new vaccines.

Although it wasn’t until 2 December 2020 that the United Kingdom became the first Western country to approve the use of any COVID-19 vaccine, after the Medicines and Healthcare products Regulatory Agency gave temporary regulatory approval for the Pfizer–BioNTech vaccine, markets already started to recover after 20 March 2020.

This period marks a highly unusual time in markets, as societal disruption coincided with economic crisis and asset price devaluations, while the speed at which markets reacted to the various developments was unusually fast.

As such, it remains a valuable test case for investors to gain insights into portfolio resilience.

Youssef Louraoui, an academic from the French business school, Ecole Supérieur des Sciences Economiques et Commerciales (ESSEC), has conducted a study into how commonly-used investment factors, including value, momentum, quality and size, reacted to the pandemic environment.

Louraoui found that some factors reacted much stronger to the increased volatility than others.

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While all factors experienced increased volatility during the pandemic onset, the speed and extent of recovery varied, reflecting the diverse characteristics and investor sentiments associated with each factor – Youssef Louraoui

“While all factors experienced increased volatility during the pandemic onset, the speed and extent of recovery varied, reflecting the diverse characteristics and investor sentiments associated with each factor,” he wrote in a paper, published on 4 January this year.

“The pronounced spikes during the pandemic’s early months are indicative of the market’s initial reaction to an unprecedented global event, while the subsequent periods show the varying degrees of resilience and recovery across these factors,” he said.

Louraoui used a statistical model, called the Generalised Autoregressive Conditional Heteroskedasticity (GARCH), which is used to estimate the volatility of financial returns and is known for its ability to model time-varying volatility.

This model enabled him to quantify and compare the evolving volatility levels across various equity factors.

“The GARCH analysis revealed…, there is some volatility clustering, particularly during the early stages of the pandemic.

“This was characterised by significant peaks in the fitted volatility, aligning with actual market returns, thereby illustrating the heightened market sensitivity to the unfolding crisis,” he said.

Louraoui found that certain factors, including minimum volatility, showed resilience, since they exhibited lower volatility levels compared to other factors, such as momentum or value, which displayed heightened volatility during the same periods.

The momentum factor adjusted more quickly to market changes induced by COVID-19.

“This could be due to the momentum strategy’s characteristic of following recent trends, which might have aligned with the swift recovery in certain market segments post the initial shock,” he said.

The quality factor showed fewer volatility spikes than the momentum or minimum volatility factors, which seemed to indicate that high-quality stocks, typically with strong balance sheets and profitability, may have provided some defensive characteristics during the market turmoil.

The size factor, however, showed substantial volatility, more than what the model predicted. Smaller companies turned out to be the most vulnerable to the economic impacts of COVID-19, and this was reflected in their risk profile.

Value stocks also experienced extreme negative returns during early 2020, which showed that they were not immune to the initial shock. Louraoui says this could possibly be the result of their sensitivity to economic cycles.

But he also found that value stocks converged relatively quickly to the fitted volatility, which might indicate that value-style companies may have provided some degree of protection as markets processed the pandemic’s potential long-term effects.


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