I think we can all safely say it’s been a roller coaster ride of a week, with the slow drip of US election results keeping many on the edge of their seat and up late at night anxiously awaiting the final votes to be counted. At the time of writing, it would appear that the American people have chosen Joe Biden and Kamala Harris to be the next leaders of their country. However, despite the momentous results of this historic election, the suspense is likely to continue as the Trump administration pursues legal action to challenge the validity of the votes.

Of course, uncertainty in the White House can lead to increased volatility in the markets and as we’ve shown in past posts, much of this will be driven by Market Sensitivity. This week, we’ll be revisiting the beta-targeting election basket that we built a few weeks ago to see how it has held up since it was constructed on Oct 16.

Has Market Sensitivity Been Rearing its Volatility?

Interestingly, the week before the election was much more tumultuous than the week after the election. From Oct 23 to Oct 28, the S&P 500 took a tumble of roughly 550 bps, only to rebound by 260 bps by election day on Nov 3. This was the trend across most areas of the US markets, with the Russell 2000, Nasdaq 100, and others following a similar behavior.

Market Sensitivity experienced this volatility as well, falling 180 bps from Oct 23 to Oct 28 and gaining back almost all of that loss by Nov 3.

Any portfolio with outsized exposure to Market Sensitivity would have seen performance rocked by this factor’s volatile movements.

Revisiting the Beta-Targeting Basket

A few weeks ago, we built a market-neutral, beta-targeting basket that was designed to target the Market Sensitivity factor. This basket can be used to offset any high or low Market Sensitivity exposures in portfolios to neutralize the overall exposure and protect performance from being driven by this factor. As a recap, you can see that this basket has very high exposure to the Market Sensitivity factor and low exposure to the other style factors.

As a result of this high factor exposure, the performance of the basket over the past couple weeks has been almost completely driven by Market Sensitivity.

Neutralizing Beta Exposure Around the Election

For investors looking to mitigate risk from Market Sensitivity in their portfolios, the beta-targeting basket can be used to offset the unwanted exposure to this factor.

Let’s take an example where a US long/short portfolio has a high negative exposure to Market Sensitivity. The portfolio below was consistently underexposed to this factor going into the election.

Given this large underexposure, the portfolio’s performance was heavily driven by Market Sensitivity.

This portfolio is a prime candidate for a basket to neutralize the influence of the Market Sensitivity factor. To test this, we simulated a new portfolio as of Oct 16 with the same positions as the original portfolio, but we included a long position in the beta-targeting basket shown above, with the goal of pushing Market Sensitivity exposure as close to 0 as possible.

As the table and charts below show, the resulting beta-hedged portfolio had improved overall performance and in particular, Market Sensitivity had a much lower impact.

The original portfolio’s performance contribution from Market Sensitivity was very volatile and heavily drove overall
performance (blue) whereas this factor’s impact was mostly muted in the simulated portfolio (purple).

In this case, our beta-targeting basket did exactly what it was designed to do! From an ex-ante perspective, this basket has also reduced the total risk in the portfolio and especially the Market Sensitivity risk.

The simulated portfolio including the beta-targeting basket not only would have been well positioned to weather the market volatility going into the election, but it is also now better protected on a go-forward basis from any tumultuous market movements from Market Sensitivity.

Looking Ahead to More Uncertainty

Similar to how the weeks going into the election were filled with market turbulence, the weeks (and possibly months) coming out of the election are likely to be uncertain as well. It’s quite possible that the worst of the market volatility is yet to come and given what we know about Market Sensitivity during election periods, it would be prudent for investors with heavy over- or underexposure to this factor to focus on ways to neutralize the exposure and protect the portfolio from undesired dispersion.

If you are interested in exploring methods for reducing Market Sensitivity exposure in your portfolio, please reach out to us and we’d be happy to dig into the various options with you.

US Market: 11/02/20 - 11/06/20

• The market posted its best performance since June this week, and futures are looking slightly up as the major networks declared Joe Biden the winner of the US presidential election on Saturday.
• We received some encouraging economic news as total non-farm employment rose 638,000 in October and the unemployment rate ticked down to 6.9% vs. consensus expectations of 7.6%.
• Initial jobless claims came in a bit worse than expected at 751,000 vs. the 735,000 estimated for the week ending Oct 31.
• Meanwhile COVID 19 infections continued to surge unchecked across the country, increasing the risk of renewed shutdowns.

Normalized Factor Returns: Axioma US Equity Risk Model (AXUS4-MH)

Methodology for normalized factor returns

• Profitability rose above the mean and headed higher into positive space (recent bottom was -1.09 SD below the mean on 10/7).
• Value also saw some positive normalized gains as it now sits at -0.02 SD below the mean.
• Size continued its decline, albeit at a slower pace, and appears to be poised to enter Oversold territory.
• Volatility fell by 0.25 standard deviations and now sits at -0.5 SD below the mean.
• Earnings Yield was the biggest loser after exiting Overbought space last week and continues to head back down towards the mean after peaking at 1.53 SD above the mean on 10/8.
• US Total Risk (using the Russell 3000 as proxy) increased by 57bps

Normalized Factor Returns: Axioma Worldwide Equity Risk Model (AXWW4-MH)

Methodology for normalized factor returns

• Unlike the US, the Size factor was the week’s biggest winner worldwide, up +0.36 standard deviations.
• Value and Profitability both saw slight positive gains in another quiet week for global factors.
• Volatility ended up perfectly flat on the week, hovering at -0.01 SD below the mean.
• Earnings Yield saw continued weakness, continuing its slow decline further into negative space. This factor was +1.53 SD above the mean on 10/7.
• Global Risk (using the ACWI as proxy) increased by 82bps this week as the global community continued to struggle with the coronavirus and subsequent lockdowns.

Please let us know if you’d like to better understand your own exposure to Market Sensitivity or learn more about building factor-targeting baskets.

Regards,
Alyx