While factor behaviour tends to be consistent in market crashes and corrections, individual factor performance varies over the medium term. As such, institutional investors should maintain diversified exposure across key equity factors including value, quality, momentum, size and low volatility, according to a new paper by Mercer.

The paper explored the past three financial crises: the coronavirus crash, the global financial crisis and the dot-com bubble. “As we might expect to see, quality and minimum volatility factors tended to outperform during the thick of a contraction, as investors sold assets perceived to be higher risk in favour of those perceived to be safer,” the paper noted. “In contrast, value and small size factors generally led the market in an economic recovery.”

In the case of the dot-com bubble, the crisis was driven by a valuation bubble in which growth stocks reached unsustainable levels. The global financial crisis, on the other hand, was driven by a debt bubble. “Given these differences, factor performances around each crisis were, not surprisingly, also different,” said the paper. “That said, the market recovery for both periods was consistent in that value and small cap led, while low volatility, quality and momentum factors all lagged by a significant margin.”

The coronavirus situation is different because it was driven by a shock independent from the business cycle. Factor performance during the sell-off was similar to that of the global financial crisis, the report noted, with low volatility, quality and large-cap style factors outperforming and small cap and value factors lagging. One difference with the coronavirus crisis and recent recoveries, added the paper, is that the value factor didn’t bounce back.

“While the stock market recovery has been swift so far, the extent of the underlying economic fallout is yet to be seen,” it noted. “As a result, the jury is still out as to whether the market recovery, to date, will be sustained. History suggests that if the current up-trend continues, value and small size factors should be rewarded, but if the news flow deteriorates and markets reverse or plummet into a second dip, quality and low volatility should lead.”

Overall, the paper suggested that investors avoid prioritizing a tilt at the expense of minimal exposure to other well-known premia. “We cannot know what lies ahead or how financial markets will respond. However, by diversifying exposure across multiple return drivers, we believe investors will have a greater chance of ensuring that their equity portfolio is sufficiently robust to weather short-term market volatility, while also being positioned to deliver favourable risk-adjusted outcomes independent of what shape the recovery ultimately proves to take.”