Before we take the plunge into this week’s spotlight on the election, I’d like to take this opportunity to invite you to join Omega Point’s Chris Martin and Qontigo’s Melissa Brown this Tuesday at 11:30 a.m. ET for the second webinar in our 4-Part “Best Practices in Hedging” series: Simulation and Testing of Your Hedging Strategies. Also, no worries if you missed the series kick-off webinar at which I had presented this past Tuesday, you can access the full recording and PDF slide handouts by registering via the following link: Creating Custom Hedge Baskets.
While this research focused on sector effects, this led us to the question of how this translates to broader systematic style and sector factor effects. More importantly, if factors have an unusually high or low impact during elections, what does this mean for how active stock pickers may fare during the upcoming election?
Dispersion as a Measure of Opportunity
For the first exploration of our 2020 Election Series, we will analyze whether factor effects are more or less pronounced during an election cycle and what this may mean for active managers. To help construct our analysis, we borrowed a concept from the S&P Dow Jones Indices research referenced above. To measure active investor opportunity for adding value, they use the concept of dispersion, which is the cross-sectional standard deviation of monthly returns for a universe of stocks. Higher dispersion is a boon for skilled active managers who can better take advantage of a larger range of returns (as long as they’re on the winning side of those returns). For our analysis, we leverage a similar measure of dispersion for equal-weighted Russell 3000, 2000, and 1000 universes.
Is Dispersion Good for the Fundamental Investor?
While total dispersion is a meaningful measure, it does not alone distinguish between active stock pickers or active factor players. However, one of the benefits of using a measure like dispersion is that it can be broken down similarly to how one might decompose returns, which allows us to tease out the nuances of dispersion drivers. Using the Axioma US 4 Medium Horizon risk model, we can decompose the monthly returns for each constituent in the Russell 3000 into realized return attributable to style and sector factors and the return attributable to idiosyncratic return, or alpha. With this data, we can rely on the following approximate relationship to calculate the percent contribution to total dispersion from factors vs alpha:
The Election Effect
At this point you might be thinking, so what, how does this tell me how active managers will fare during the election? To help answer this question, we can take the analysis above and segment it by election periods. First, since US elections always occur in early November, let’s see if there is a “November Effect” on the dispersion.
Factor Awareness During Elections is Key
Times may finally be changing for the better for active investors, with total dispersion increasing since 2019 which highlights increased opportunities for active management to shine. While the active management opportunity is magnified during election periods, the alpha opportunity is dampened during these times so fundamental investors need to be especially wary.
US & Global Market Summary
US Market: 10/5/20 -10/9/20
Normalized Factor Returns: Axioma US Equity Risk Model (AXUS4-MH)
Normalized Factor Returns: Axioma Worldwide Equity Risk Model (AXWW4-MH)
Please don’t hesitate to reach out if you’d like to discuss dispersion in further detail, or discuss other factor trends that may be impacting your portfolio.