Qontigo Insight Quarterly — October 19, 2022

Qontigo Insight Q3 2022 Quarterly Risk Highlights: Markets fell but so did volatility

by Applied Research Team

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Top Takeaways:

Market returns were negative in Q3, yet volatility fell from the end of Q2
- Risk fell when markets rallied, but remained steady as they turned down
- We found a number of drivers of the lower risk, which is unexpected
- Some style indices’ active risk fell as well
- Volatility turned back up in late September
US expected risk remains higher than that of any other region, and although below the levels of prior bear markets and down recently is still in the 88th percentile relative to history. The US still contributes more to the STOXX Global 1800 risk (and weight) than it has in at least seven years
Developed markets currency risk (in USD) has continued to rise, as some currencies have hit decades-long lows relative to the US dollar. The increase in volatility was led by GBP and JPY. Country risk fell for most countries

Emerging markets risk is now only 77% of the risk of developed markets, hitting at least a 15-year low relative level
Certain macroeconomic variables had returns of unusually large magnitudes, with GB inflation seeing one of its most positive quarters ever, while US and EU Terms Spreads, Gold and Oil had highly negative returns. Overall, macro factors were a huge driver of the market in Q3
Momentum had a great quarter in most regions, but US Profitability had its worst quarter in the history of the model. Value, Earnings Yield and Dividend Yield produced disappointing returns in most regions, and despite the down market, Market Sensitivity had a positive return
Turmoil in the UK may have led to different factor behavior there, with Value and Profitability faring well, a huge tilt toward large cap stocks and a two-standard deviation negative move in Exchange Rate Sensitivity

Short-horizon predicted volatility

Source: FTSE Russell, Qontigo

We typically expect falling markets to lead to higher volatility, as declines tend to be large in magnitude, but that is not what we saw in Q3 – although most markets fell, so did predicted volatility
Although it fell from the end of Q2, it is higher than a year ago in all indices except STOXX Japan 600 and STOXX China A 900
Volatility is lower than six months ago in European indices, higher in Canada and Australia and roughly the same in the US
US large and small cap indices maintained their positions as the riskiest while the UK remained the lowest*
We discuss the seemingly incongruous decline in volatility in the next section

*when denominated in GBP

US Short-Horizon Fundamental Predicted Risk

Although predicted volatility for the broad US market fell in Q3, the reading is in the top 12% of values since 1982
Risk remains more than 55% higher than it was at the beginning of the year, and almost 130% above the September 2021 low

Source: Qontigo. Risk figures are based on the Axioma Market Portfolio US-LMS, which represents the broad US investment universe

Why Has Volatility Fallen? We See Several Reasons (At Least)

Most of the decrease occurred during the market rally (July-mid-August)
Asset-asset correlations fell about 25% from the end of Q2
Average asset volatility peaked in July and has declined
Certain industry-market correlations have also moved closer to zero, notably Oil and Gas/Energy
The incidence of large daily returns fell in Q3 (7.6% of days had return >2% or <-2% in Q3, vs. 20.6% in Q2)
Trading volume remains quite low

It is not just benchmark risk that fell

Volatilities of many currencies rose from Q2, but currency risk rose mainly in DM

DM currency risk rose 9% in Q3, while EM currency risk was flat. GBP and JPY both saw substantial volatility increases
More than 78% of DM currency pairs saw an increase in their correlations, vs. less than half of EM pairs
In contrast, DM Country risk fell almost across the board in Q3, following sharp declines in Q2.
More country-pair correlations rose than fell, so lower aggregate was driven by decline in country volatility
DM country risk fell more than 27% and EM country risk fell 16%

Emerging vs. Developed: Benchmark Risk

While risk fell in Q3 it fell more for the STOXX Emerging 1500 than for the STOXX Global 1800
The ratio of EM to DM risk hit a new low in Q3, ending the quarter at about 77%
Adding EM stocks to a DM or all-world portfolio could lower active risk, but should also be closely monitored

Source: Qontigo
*Based on Axioma Market Portfolios, Emerging Core and Global Core

Macro Factor Returns: Most fell in the top or bottom quintile as macro factors drove market returns

GB Inflation’s return was positive as BEI remained high. In the US, TIPS rose more than the 5 year, so BEI fell
The US Term Spread return was also negative, as 6-month bill yields advanced far more than 10-year bonds’. Spreads have narrowed since May
Both Gold and Oil saw extremely negative returns

Macro factor influence was substantial in Q3, more as the market went up

Macro factors contributed positively to returns in Q3, driven by term spreads
Although US Inflation dragged returns down (positive exposure + negative factor return), EUR and JPY credit spreads, and GB and EU Term Spreads helped returns and offset the US Inflation drag
Contact your Qontigo representative for similar analysis on other indices or different time periods

Factor returns were relatively subdued in Q3, although many were in opposite directions from expectations, including Value, Earnings Yield and Profitability

Q3 2022 Performance

Note: an “*” indicates that the return was two standard deviations or more away from the long-term average, with the standard deviation defined as the risk forecast at the beginning of the period. The highest and lowest regional return for each model is highlighted.

A Closer Look at US Style Returns:

Momentum had a very strong quarter, and YTD return has turned positive
Value-oriented factors had a tough quarter, and profitability had its worst quarter since the inception of the US model in 1982

*Normalized: (Actual Return – Long-Term Average)/Realized Standard Deviation
**Rank: Percentile relative to long-term history. Bold means top or bottom decile
Red denotes typically compensated factors with big returns opposite to the long-term average

A Closer Look at Trading Model Style Returns: Trading-specific factors

More-crowded stocks outperform on average, but the degree of outperformance in Q3 was large
Stocks with high downside risk (the most volatile names) fared particularly poorly in Q3, and the YTD reading is almost two standard deviations below average

US Factor Alternative Portfolios

Source: Qontigo
Notes: Returns are scaled to a factor exposure of 1 for comparability. Differences over 1% for the quarter and 2% YTD are highlighted

We created variations of factor-mimicking portfolios with exposure to the factor in question and no exposure to any other factor:
- Monthly rebalancing rather than daily
- Large-Cap universe rather than all-cap
- Shorting only allowed up to the benchmark weight (“Long-Only”)
Factors have almost all done better among large cap stocks in both Q3 and YTD
Momentum’s performance was better with monthly rebalancing
Earnings Yield did much better on the short side, as did Profitability and Low Volatility, but Value and Momentum had higher returns from the long side