A Look at Changing Factor Exposures in an Evolving Market

A Look at Changing Factor Exposures in an Evolving Market

By Jack Forehand, CFA, CFP® (@practicalquant) —

The market has seen some major changes since the 2020 market bottom. It would have been very difficult to predict the massive rally we have seen since that time given what we knew then. But the changes in the market beneath the surface since the bottom are in many ways more interesting than its change in direction. The growth dominated market we had seen for a very long time at that point has now been replaced with a value led one. And the damage done to the most expensive stocks has been massive, with many of them now 50% off their highs.

Given the recent moves in the market, both in the indexes and behind the scenes, I thought it would be interesting to take a look at the highest scoring stocks from each of the major factors and how their composition has changed, both since the market bottom and in the past year.

But before I do that, just a quick description of how we calculate factor rankings. For each of the major factors (value, momentum, quality and low volatility) we have selected a series of metrics that we think best represent that factor. For example, with value we use the major valuation ratios like the PE ratio and EV/EBITDA. We then rank all stocks using each metric and sum those rankings to create a composite ranking. We then sort all stocks by that composite ranking and assign a score based on their percentile. A value rank of 99 would indicate that a stock is in the top 1% of all stocks in our investable universe (about 3000 stocks) using that composite ranking.

What I often find most interesting with these rankings is how the top stocks from a specific factor rank using the other factors because this can help identify changes in the market beneath the surface. 

Here is a look at the top decile of each factor and how the exposure of the stocks within it to the other major factors has changed in recent years.


Top Value Decile   
Low Volatility506037

Given that value has seen its performance improve significantly in the post bear market period, this chart shows what you might have expected it to. At the market bottom, the stocks in the top value decile had significantly below average momentum. And their subsequent run in the months after was also derailed, with growth reasserting its dominance. But the recent market decline has put value back in the driver’s seat and the momentum in the bottom value decile is the best it has been in a long time.

The other interesting thing to note is that the average ranking for the top value decile for both quality and low volatility has been rising. The fact that the value rally has been driven by lower quality companies has allowed value investors to find better quality companies within the cheapest group of stocks than they could have back in 2020.


Top Momentum Decile   
Low Volatility412540

Another side effect of the better performance from value is that it has become aligned with momentum and the top momentum decile is now much cheaper than it was. The average value score of the top momentum decile has doubled since that 2020 bottom. In the past year in particular, momentum has also simultaneously increased its exposure to quality and low volatility.


Top Quality Decile   
Low Volatility747772

The top decile of the highest quality stocks hasn’t seen nearly as much change as value and momentum. High quality stocks have gotten cheaper since the pandemic bottom, but the other two factors have held fairly steady. Quality and Low Volatility tend to be correlated with each other so the consistency of those scores is not a surprise.

Low Volatility

Top Low Volatility Decile   

Low Volatility was coming off a long stretch of outperformance in early 2020. So it was probably due for a rough patch. And it had one, as you can see from the fact that the momentum in the top decile stocks fell from 2020 to 2021, and the fact that the stocks also got cheaper. But that has reversed some in recent months, as investors have moved toward less volatile stocks due to the market turmoil.


Top Growth Decile   
Low Volatility272122

Growth isn’t as factor we follow, primarily because  it  hasn’t been proven as a factor that works over time . But I thought it would be interesting to look at the most expensive decile using our value composite to see how the factor exposures within it have changed. The end result of that is pretty much what you would expect. The average momentum of the stocks in that expensive decile has been cut in half in the past year, as growth has struggled. It also likely isn’t a surprise that the quality and low volatility scores in that most expensive decile have remained consistently low.  

In the end, data like this is more about understanding the behind-the-scenes machinations of the market than anything actionable. But understanding the exposures within factors can be helpful in thinking about building investment strategies as well. For example, when value and momentum come together, as the chart above shows they have recently, it can offer an opportunity for long-term investors. The same is true of situations when low volatility stocks also have significant exposure to value. Understanding the details of factor exposures can help all of us better understand what we are getting when constructing factor portfolios.

Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at Validea.com and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.