National Conference on Public Employee Retirement Systems

The Voice for Public Pensions


Which Equity Factors Perform Best When Interest Rates Are Falling?

By: Pradeep Velvadapu, Russell Investments

In this article, pension plan sponsors learn how different interest rate environments can impact key equity factors.

This is an excerpt from NCPERS Spring 2024 issue of PERSist, originally published April 25, 2024.

For pension plans, changes in interest rates can have outsized impacts on funded status, as liabilities are more sensitive to fluctuations in rates than assets. For plans that have not fully hedged their interest-rate risk, falling rates typically increase a plan's liabilities by more than its assets, leading to a deterioration in funded status. With the Fed poised to begin lowering interest rates soon, plan sponsors may need greater returns from their assets in order to offset swelling liabilities. Amid this backdrop, it's important for plan sponsors to evaluate different investing strategies to get the most out of their portfolio.

One potential strategy to consider is equity factor investing. Factors are the underlying characteristics that drive returns of stocks, bonds and other assets. For instance, Value, Momentum, Quality, and Low Volatility are four common equity factors that have the potential to deliver excess returns over the long term. Factor investing targets exposure to these factors to help maximize a portfolio's return and manage its risk.

With markets rallying on the likelihood of rate cuts by mid-year, we thought it would be prudent to assess how key equity factors typically perform during and after times of monetary policy changes. So, we examined historical periods of different interest rate regimes and inspected factor performance during and immediately after these regimes. The figures below show the results of our findings.

During periods of rising interest rates, Momentum (MOM) was the strongest performer with a +20.2% return and a high 63% hit rate. Quality (QMJ), Size (SMB), and Value (HML) were next, with positive performance of +8.2%, +7.3%, +6.6%, respectively. Investment (CMA, Conservative minus Aggressive) and Profitability (RMW) were significantly weaker with respective performances of +3.8% and +2.2%.

Interestingly, when compared to a rising interest rate environment, we see that the same factors performed the best. When interest rates were going down, Momentum (MOM) and Quality (QMJ) were the highest performers with returns of +13.9% and +11%, respectively. However, we saw a change in the Profitability (RMW) factor with a positive return of +8.8%, compared to only +2.2% during rising interest rates. We saw the reverse with Value and Size, with those factors being the weakest performers with their average return down by -3.6% and -5.1%, respectively, compared to periods of rising interest rates. The Investment (CMA) factor didn't have a large change between the two regimes.

Not surprisingly, the market experienced the strongest performance when monetary policy was in a static state, with a strong +27% return. During those periods, Investment (CMA), Value (HML), and Profitability (RMW) were the best performers. Momentum (MOM), Quality (QMJ), and Size (SMB) were the weakest performers.

Momentum (MOM) and Quality (QMJ) were the best performers in both rising and falling interest rate regimes. During periods when interest rates were flat and markets were in a recovery phase, Profitability (RMW), Value (HML), and Investment (CMA) were the best performers. Size only performed well in rising interest rate regimes and was the weakest performing factor in other regimes.

Finally, we looked at the performance of the factors one year after the end of each regime. Here, we observed a low distinction in returns following peak interest rates, with Value (HML) performing the worst (+4.5%), while Profitability (RMW), Momentum (MOM), and Quality (QMJ) were the best performers (+6.5%, +6.2%, +5.8%, respectively). During the market recovery phase, one year following the lowest point in interest rates, Size (SMB) was by far the best performer (+12%), followed by Investment (CMA) and Value (HML), with returns of +6.0% and +5.6%, respectively.

The one-year period following flat interest rates is typically associated with a shift from recovery to an expansion phase of the market. Here, we saw a shift in leadership, with Momentum (MOM) and Quality (QMJ) as the best performers, with returns of +10.3% and +5.4%, respectively. Size (SMB) and Value (HML) were next at +5% and +4%. Investment (CMA) and Profitability (RMW) were the weakest, with returns of +3.3% and +2.7%, respectively.

The bottom line
Our research shows that during periods of declining interest rates, the Momentum and Quality factors were the strongest performers, while the Value and Size factors were the weakest. Plan sponsors considering making tactical adjustments to their portfolios ahead of the Fed's shift to monetary easing should keep this in mind.

About the Author
Pradeep Velvadapu is director of quantitative investing for Russell Investments' direct investments business. Pradeep works within the research group and is responsible for overseeing the research and development of multi-asset quantitative strategies within Russell Investments. In addition, Pradeep manages the data and infrastructure necessary to support the broader research team.

Pradeep joined Russell Investments in 2006 as a research analyst within Russell's index business, where he was responsible for research and development of new index and investable products.



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