Factor focus: quality and momentum triumph in third quarter

The quality and momentum investment styles are expected to continue to lead the way in the months ahead. 

Momentum and quality were the best-performing investment factors over the third quarter of 2020 and may continue to be so for the rest of the year, according to the latest WisdomTree Quarterly Equity Factor Review.

Pierre Debru, director of research at WisdomTree, notes that the third quarter of the year started with equities continuing to perform well. Over the period, global equities continued the rally they had experienced since the end of March and erased all their losses since the start of the year.

However, during September, the last month of the quarter, markets started to slip. Debru notes: “Since early September, the rally seems to have stalled on fears of a second wave for the pandemic in Europe, Brexit uncertainties and a lack of a new agreed fiscal stimulus package in the US. This may not be so surprising with the US elections only a few weeks away and markets predicting an increase in volatility and overall uncertainties for the start of the fourth quarter.”

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As a result, there is a wide variation in performance between the first two months of the quarter and the last month. In July, the MSCI World index returned 4.8%, followed by 6.7% in August. However, in September performance is in negative territory, with the index down 3.4%.

This variation in performance means that quality and momentum were the two best-performing factors in the MSCI World index in the third quarter. Over the course of the three-month period, quality returned 1.3% and momentum 3.3%. In contrast, value returned -7.9%; size (smaller companies) -0.05%; minimum volatility -3.2%; and high dividend -4.8%.

Debru notes: “In such a contrasted environment, only two equity factors managed to deliver outperformance in all three calendar months: momentum and quality. Both factors managed to capture the rally and more than match the market-cap-weighted index performance while cushioning the slight drawdown.”

The quality factor refers to stocks seen as high quality owing to having more stable earnings, stronger balance sheets and higher margins. The momentum factor refers to the tendency of stocks that have performed well to continue to perform well, at least in the near term.

Debru refers to these two factors as “all-weather factors” that tend to do well across different market environments.

In contrast, other factors were disappointing. Both size and value are cyclical factors and so are expected to do better or worse depending on the overall performance of the market. However, both factors failed to outperform in either July or August when markets were up.

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Meanwhile, as expected, minimum volatility performed well in September, but failed to deliver performance in July and August.

Debru says he expects market volatility to continue until the end of the year, meaning that both quality and momentum may continue to do well. He argues: “In such an unpredictable world, it is hard to discount the possibility that the all-rounders (quality and momentum) continue to benefit.”

However, he says that in future quarters there is the possibility that the current large-cap tech stocks dominating the market could see a slip in performance, and therefore weighting. “If and when that happens most factors including quality should benefit, while momentum may suffer from such mean reversion,” he says.