Building Short-Term Resilience Into Long-Term Premia

Strategies designed to deliver risk premia over time need help to survive potential potholes and hairpin corners along the way.

Factor investing is not a short-term game.

We know that certain risk factors can deliver premia to investors over the long term, but the competitive nature of markets dampens the profitability of short-term, easy-to-hold portfolios. It’s the very difficulty of holding risk factors over time that generates their premia.

To understand why that is, let’s think about one of the most commonly used risk factors: value. It is risky to hold stocks that trade at relatively low valuations. Their earning potential may be misunderstood by investors; but then again, they may just be poor companies whose earnings are about to decline. To resolve that risk—and confirm whether a business is undervalued or poor—is likely to take some years. Investors are paid the value risk premium in exchange for braving those years of uncertainty.

In short, risk-factor or risk-premia investing is about the value of your investment converging with intrinsic or fundamental value over the long term, and the rewards can be substantial. By contrast, when we are trading convergence of a stock price back to a short-term moving average, the rewards tend to be much smaller. That is because the uncertainty is resolved much sooner, which makes the risk smaller, which in turn attracts many more competitors who are prepared to “arbitrage” away these minor price divergences.

Making the Trend Your Friend

That’s not to say that there is no opportunity to profit from the short-term volatility that results from highly fluid economic conditions and patterns of consumer behavior, however. One of our objectives at Neuberger Berman Breton Hill is to improve portfolio-level outcomes for risk premia investing by targeting factors that we believe can benefit from such market behavior.

In our view, one useful portfolio construction approach is based on the observation that long/short equity risk premia portfolios can be effectively complemented with the risk premia that come from trend-following.

In Figure 1 the SG Trend Index, which represents the returns of trend-following managers, has an average correlation of 0.08 with four standard risk premia, represented by Morgan Stanley’s Long/Short factor indices. In this case, adding a trend-following allocation to a standard risk premia portfolio would have helped to diversify the portfolio and smooth out return patterns. On reflection, this is intuitive: remember that risk-factor investing is about the value of your investment converging with fundamental value over the long term; a substantial trend in the price of an asset, by contrast, often takes the price further away from fundamental value.

Figure 1: Correlation of SG Trend Index to Risk Premia

Monthly Returns: February 2007 – March 2021

Source: Bloomberg, Neuberger Berman.
Value, Quality and Momentum are represented by the Morgan Stanley U.S. Value Custom Index, the Morgan Stanley U.S. Quality Custom Index, and the Morgan Stanley U.S. Momentum Custom Index. Low Risk is represented by the Morgan Stanley U.S. Realized Volatility Custom Index, inverted so that it is long stocks with lower volatility and short stocks with higher volatility. Past performance is not indicative of future results.

One area of research for us has been to take this observation a step further by seeking to create a more targeted set of underlying assets in our trend following program, which is designed to complement the rest of our risk premia portfolio in specific scenarios where it is most likely to perform poorly.

Challenging Environments for Risk Premia Investing

The market response to the COVID-19 vaccine announcement in November 2020 is an example of such a scenario. During the pandemic, consumer demand for travel and leisure has been highly sensitive to positive developments in the treatment and containment of COVID-19. As a result, on November 9 last year, when Pfizer announced a 90% efficacy rate for its vaccine in a late-stage trial, there was a substantial rally in deep value stocks in industries such as energy, hotels and retail.

In many respects we can characterize the post-vaccine environment as an early-stage recovery for a significant segment of the market. Although early-stage recoveries are associated with high performance for many traditional risk assets—as we have seen in the performance of equities and credit over the past six months—fully hedged long/short equity factor portfolios can find these pivots challenging for two reasons:

1. Over time, quality, low-risk and momentum factors can generate alpha and be valuable contributors to a diversified multifactor risk premia portfolio. But the stocks that tend to drive market returns in the early stages of economic recoveries generally exhibit poor profitability and financial weakness, high volatility and negative momentum.
2. The value factor has some potential to create exposure to recovery stocks, but those recovery stocks are unlikely to be very concentrated in portfolios built on a more diverse set of measures of value, which tend to perform better over the long run. That’s because recovery stocks are often cheap in terms of book value, but not necessarily cheap on other metrics: many companies impaired by COVID-19 would not have passed a value screen because they looked expensive on the basis of earnings-to-price or cash flow-to-price, following the hit to their current earnings and near-term earnings expectations.

These effects were apparent in the market recoveries from both the 2009 Global Financial Crisis and the COVID-19 pandemic (figure 2). As you can see, the value factor held its own during the 2009 recovery, but underperformed in the more recent rally for the reasons described above. The other three factors underperformed substantially through both periods.

Figure 2: Factor Returns During the Recoveries from the Global Financial and COVID-19 Crisis

Source: Bloomberg, Neuberger Berman.
Value, Quality and Momentum are represented by the Morgan Stanley U.S. Value Custom Index, the Morgan Stanley U.S. Quality Custom Index, and the Morgan Stanley U.S. Momentum Custom Index. Low Risk is represented by the Morgan Stanley U.S. Realized Volatility Custom Index, inverted so that it is long stocks with lower volatility and short stocks with higher volatility. Past performance is not indicative of future results.

Tailoring the Trend

In view of this, we have expanded our own trend following program to include hedged baskets of equities customized to aim for better performance at times like these, when traditional long/short equity factors are challenged.

The long securities in these baskets are selected based on several criteria, including valuations, ratings from our colleagues in fundamental analysis that help filter out idiosyncratic risks and traps, correlation analysis against market and risk factors, and backtested behavior of the baskets in various market regimes. The short exposure is the relevant market-cap index.

To implement this part of a portfolio, we systematically follow the trend of an internally built index and take positions accordingly, accompanied by execution and money management rules typical of trend-following, such as stop-loss controls that respond to drawdowns.

The road to capturing risk premia is by definition a long one. It is also likely to feature a lot of potholes and a few hairpin corners, which can jolt a risk premia strategy or even throw it off course if they are not managed well. Our work on trend-following is part of our commitment to finding ways to build risk-premia portfolios that seek to produce better outcomes in realistic market scenarios, including those in which prices are subject to behavioral trends, when risk premia are most likely to underperform.