Lesson two: Managing factors was more critical than picking stocks
Covid-19 unleashed a surge of volatility, manifested in a torrent of sharp movements across global financial markets, as the epidemic quickly escalated to a pandemic.
MSCI’s analysis shows that forecast volatility reached levels higher than those seen during the global financial crisis of 2008.
Cross-sectional volatility (CSV), a measure of return dispersion across assets, rose substantially. Importantly, cross-sectional dispersion attributed to common factors rose more sharply than stock-specific volatility.
The sharp increase in cross-sectional volatility shows that, far from indiscriminate selling, markets adjusted prices according to each asset’s factor and specific risk.
As a result, managing factor exposures became more critical than picking the right stocks. Avoiding airlines, for example, when the crisis struck was far more important than choosing between British Airways and American Airlines.
This environment provided a significant opportunity for active managers, offering them a hunting ground to seek opportunities for generating alpha from active stock selection and from managing factor exposures.
Factors such as momentum, size, profitability and ESG offered high positive excess returns, while other factors such as yield, leverage and long-term reversal suffered sharp declines during the crisis.
Historically factors and stocks have contributed equally to performance on average, MSCI’s analysis found however that during the crisis, active returns attributed to factors increased considerably in the first quarter of 2020.