Over the last year, correlations between beta and risk have weakened compared to historical levels. While the two measures of risk are usually highly correlated, beta and risk don’t always mean the same thing. Over the last 12 months, we’ve observed lower risk stocks outperforming high risk stocks while high beta stocks have outpaced low beta stocks, confirming a breakdown in the relationship between beta and risk. In fact, this divergence persisted during the market decline in the first quarter, when low risk names provided protection whereas low beta names did not.
The divergence between beta and risk is evident when comparing exposures across certain sectors. For example, many companies in Financials are high beta, but also low risk (table 1). This can in part be explained by the relative outperformance of the sector in a high returning market environment, with lower risk from a combination of positive interest rate sensitivity and attractive valuations. Conversely, companies in Energy are low beta and high risk (table 1), as the sector has generally underperformed with heightened volatility from fluctuations in crude oil prices.
The current market environment highlights the importance of assessing risk across multiple dimensions. We believe risk is far too complex to sufficiently define and address using a single metric, which is why we’ve built multiple risk models into our robust risk management process. As market volatility increases, it will become even more imperative to view risk comprehensively, as low risk and low beta may not provide the same profile during potential market declines.
First quarter overview
The biggest headline during the quarter was the reemergence of volatility, with the S&P 500 finishing in negative territory for the first time in nine quarters. There were several notable events throughout the period, starting with the market correction in late January. Stocks recovered in the second half of February until concerns over trade protectionism and increased regulation on the technology sector resulted in a volatile correction at the end of to the quarter.
Following a historically stable year in 2017, market volatility resurfaced during the first quarter of 2018. While it is somewhat counterintuitive based on the market environment, high beta stocks outperformed low beta stocks. This can be explained by the continued outperformance of higher-beta Technology stocks for most of the quarter, along with the underperformance of lower-beta bond proxies (see below). Significantly, while not shown in these charts, market volatility rose within the quarter due to a sharp technical-based sell-off in early February, followed by a rebound, and then a sharp reversal in March of both markets and factor performance.
Growth and Momentum
The quarter was fairly consistent for the first two months, with Growth and Momentum leading market returns. Markets reversed course in March, with Growth and Momentum underperforming mostly due to the sell off Technology. In aggregate, Growth and Momentum continued last year’s stretch of outperformance backed by strong returns during the first two months of the year, while value continued to struggle.
“Bond Proxies” Underperform
Stocks with positive sensitivities to changes in interest rates outperformed during the quarter as 10 year treasury yields rose from 2.4% to 2.9% in January. Conversely, stocks in “bond proxy” sectors , such as Telecommunication Services and Consumer Staples lagged. However, these stocks performed well after the market reversal in March, providing their traditional outperformance in falling markets.