2023 Year in Review
In 2023, alpha returned to the US market! In fact, we saw the lowest percentage of factor-driven weeks (39%) since 2014. For perspective, 2022 (the most factor-driven year in our history) had almost 70% factor-driven weeks.
What’s unique about 2023 is that the alpha was accompanied by much higher levels of stock price volatility. Historically higher levels of alpha are associated with calmer or neutral markets, while 2023 saw levels of volatility only surpassed by 2008-2009, 2020, and 2022.
Some of the reasons that explain the higher levels of alpha + stock volatility are:
- Beta — in a market that’s rebounding from a tough 2022, higher Beta and Volatility stocks were associated with 94% of positive market moves. Those stocks tend to also have higher levels of idiosyncratic risk. For perspective, the Beta factor saw its highest return (7.3%) in the US since post-GFC (2009).
- Tech - tech stocks, which characteristically have higher idiosyncratic volatility were up 60.8% of the weeks in 2023. We also observed the highest rate of week-over-week “flip-flopping” in Tech exposure (25%). Meaning - when tech was in favor, it was strongly in favor and vice versa.
- Crowding pain — We observed both the highest level of positive hedge fund crowding exposure during down market weeks and highest level of positive of short interest exposure during up market weeks. These observations suggest that hedge funds were largely positioned opposite to the 2023 market narrative moreso than any other year since 2007. All things equal Hedge fund crowded stocks tend to be more volatile and idiosyncratic.
Size Factor — Most 2023 recaps will not be complete with at least mentioning the rally in the Magnificent 7. From a quantitative perspective, the Size factor saw the highest return (7.3%) in any year in our history. The only other year that came close was 2017.
Factor Influence and Market Volatility Review
2007 - Present: Classifying “Factor-Driven” and “Alpha-Driven” Markets
As a reminder, our US market analysis is built using our US Extreme Movers Portfolio. The portfolio is a weekly-rebalanced, market-neutral portfolio that invests long in the top decile of best performers and shorts the bottom decile of performers in the Russell 1000 index. The characteristics and performance of the Extreme Movers Portfolio point to the areas of the market that were in and out of favor and provide valuable insight into themes that drove stock returns.
Our US Extreme Movers portfolio began on Jan 1, 2007. Each week, we observe performance decomposition through the lens of various risk models and use quintiles to categorize the performance on a spectrum of the most “Alpha-Driven” weeks to the most “Factor-Driven” weeks. To calibrate our classification, we took the total sample of all weeks (>880) since Jan 1, 2007, and ranked them by Alpha Contribution to return percentage.
A Very Alpha-Driven Week (Top Quintile) is one where an Alpha Contribution to return is HIGH and a Very Factor-Driven Week (Bottom Quintile) is one where the Alpha Contribution to return is LOW.
Below are the Alpha Contribution thresholds that define the quintiles:
In addition to understanding what portion of the market volatility was attributable to factors and alpha, we also proxy the market volatility levels. We applied the same ranking methodology to categorize the volatility of weekly periods based on the total return of the US Extreme Movers portfolio. We categorized these quintiles from “Very Volatile” to “Very Calm.”
To break down the historical context, we segmented the historical data by calendar year and market regime to give investors a sense of how the recent and current market stack up against prior periods. Details on the thematic market regimes are below.
Aggregating Weeks into “Alpha-Driven” vs. “Factor-Driven” Periods
The availability of alpha in the markets is critical for fundamental investors. Historically, there have been periods during which the majority of volatility in the market was attributable to stock-specific nuances. These periods provide ample opportunity for stock-pickers’ competitive advantage to shine. There have also been periods that were clouded by market factors, restricting the fundamental investor’s ability to drive idiosyncratic returns.
Here, we’ve broken down the weeks in each year since 2007 according to our spectrum of “Very Factor-Driven” to “Very Alpha-Driven” and examined the percentage of weeks in each category. In doing so, we found that only 39% of the weeks in 2023 were at least “Factor-Driven,” which is the lowest percentage observed since 2014. Conversely, 33% of the weeks were at least “Alpha-Driven,” which was double what was seen in 2022 and aligned with levels from the pre-COVID era between 2015 and 2019. This means that bottoms-up, fundamental stock-pickers were much better positioned this past year to uncover opportunistic stocks whose prices weren’t over-influenced by market and macroeconomic forces.
When comparing to market regimes, we can see that 2023 presented significantly more alpha opportunity than the most recent “Rate & Inflation Downturn” period, which was characterized by supply chain constraints and increased inflation fears. It also surpassed the Q4 2018 and COVID periods, which presented significantly less alpha opportunity and more factor influence than the most recent year. Interestingly, the Global Financial Crisis was the most similar period in terms of distribution of weeks, though 2023 skewed more towards the “Neutral” and “Factor-Driven” categories and less towards “Very-Factor Driven”.
Aggregating Weeks Into Volatile vs. Calm Periods
Beyond the breakdown of Extreme Mover's performance into factor and alpha, another key area we looked at was the level of volatility. The charts below aggregate each week since 2007 on a scale of from "Very Calm" to "Very Volatile," across both calendar years and market regimes. We found that 45% of weeks in 2023 were "Volatile", which marks the highest percentage observed since the beginning of 2007. There were an additional 24% of "Very Volatile" weeks, reaching an aggregate level of 69% that has only been exceeded in 4 out of the last 17 years.
We also found that there were no "Very Calm" periods in 2023. This surpasses even the Global Financial Crisis, COVID, and the Rate & Inflation Downturn regimes, which otherwise represented the periods with the lowest percentage of "Very Calm" periods. The overall distribution of volatility levels during the COVID and subsequent Rate & Inflation Downturn regime were still highly similar to what was observed in 2023, indicating a continued elevation of volatility was present in the market over the last year.
Elevated Volatility with Factor Influence
Finally, we wanted to identify the cross-section between considerably factor-driven and considerably volatile periods over the past year. Put simply, "How often was the US market heavily volatile because of factors?" The intersection of these two categories represents periods where alpha is far less available, but stock prices are experiencing significant price movements, creating a challenging environment for fundamental investors.
The chart below presents the percentage of weeks each year categorized as at least "Factor-Driven" and at least "Volatile." When framed in this context, we can see that 2023 had half the number of factor-driven volatile weeks than 2022, which had been an all-time high. Instead, there were only 10% of weeks in 2023 that were “Very Factor-Driven” and “Very Volatile”, and 21% of weeks that were “Factor-Driven” and “Volatile.” Of the periods in our analysis, 2023 was most similar to 2021.
The percentage of factor risk weeks in 2023 was also significantly lower than that of recent regimes like COVID and the Rate & Inflation Downturn. However, it exceeded that of the FactorMaggedon + Election regime by 4% and remained over three-fold the level observed in the Post-GFC + Pre-COVID era.
Extreme Movers Exposure Analysis
In 2023, sector flows see-sawed constantly as investors weighed incoming macroeconomic news and geopolitical developments. Those sharp reversals in flows were reflected in the Extreme Movers Portfolio’s sector allocations on a week-over-week basis, particularly in Information Technology, Industrials, and Consumer Staples. The average week-over-week change in Extreme Movers allocation for Tech prior to 2023 was 16%. In 2023, that week-over-week difference jumped to 25%. Industrials jumped from a historical average of 10% up to 14% in 2023, and Consumer Staples spiked from a 7% average to 10%.
Broadly, what we found in reviewing sector behavior in 2023 relative to history was that favor diverged more strongly than ever based on “up” versus “down” markets. We measured “up” and “down” markets based on the weekly return of the US Country factor and saw a stronger “battleground” between Cyclical and Defensive sectors than we’ve seen in years past. From 2007 to 2022, Cyclical and Defensive sectors both had an average aggregate allocation of 0% which means that the market has generally traded off Cyclicals and Defensives to an equal degree. In 2023 however, Cyclical sectors had an average aggregate allocation of 5.4% which is the highest level since the portfolio’s inception.
Information Technology, Consumer Staples, and Health Care had the largest disparities between “up” and “down” markets. Tech had an average allocation of 8.4% when the overall market outperformed but a slightly negative average allocation when the overall market underperformed. Health Care and Consumer Staples, two defensive sectors, had the strongest negative allocations in bullish markets and reasonably strong long allocations in bearish markets.
The back-and-forth of investor sentiment was just as evident in style factors. Overall, investors favored risk in 2023. On average, exposures to beta, volatility, and growth factors were significantly positive while value and quality factors were muted or even negative. However, many of these factors were heavily dictated by broad market sentiment.
The table below shows the average exposure of the Extreme Movers portfolio to each style factor in 2023. We then decomposed that average based on “up” markets and “down” markets and calculated the percentile of 2023’s average relative to every year since 2007.
Beta factors’ 2023 average “up” market exposure landed in the 94th percentile since the Extreme Movers portfolio’s inception in 2007 and Short Interest’s exposure reached its all-time high which both hint at the fact that investors were eager to take risk in order to capture returns when economic outlook improved. While leaning into beta, the market tended to toss high earnings yield, interest rate-sensitive, and oil-sensitive stocks to the side. During “down” markets, investors sought safety in earnings yield, quality, momentum, rates, and oil.
We observed both the highest level of positive hedge fund crowding exposure during down market weeks and the highest level of positive level of short interest exposure during up market weeks. These observations suggest that hedge funds were largely positioned opposite to the 2023 market narrative, more so than any other year since 2007.
Style Factor Return Spotlights
In 2023, there were a handful of style factors that deviated from their long-term trends. Investors certainly felt the strong large cap rally that persisted for much of the year. Beta’s power during “up” markets was a key driver of risk and return.
Size has been a historically underperforming factor with an average yearly performance of -2.34% since 2007. Over the long term, small cap stocks tend to outperform large cap, particularly in “risk-on” environments. However, in 2023, large-cap, led by the “Magnificent Seven” outperformed small-cap companies, resulting in a 6.5% factor return in Axioma’s US4 Medium Horizon model. Size’s 6.5% return was the highest calendar year return since prior to 2007.
Not to be overshadowed by Size, Beta notched its strongest year since 2009. Prior to 2023, it has had an average yearly performance of -0.1%. In 2023, however, the Beta factor in Barra’s US Equity Model for Long-Term Investors returned 7.3%. The two most similar years historically were 2009 when the market was coming out of the Global Financial Crisis and 2020 during the COVID rebound.
The ETF Flow factor from Wolfe’s US Broad v2 model is one of the most consistent factors in terms of its negative premia with an average annual performance of -1.5% since 2007. Stocks that have seen significant in-flows from ETFs over a trailing three-month period tend to subsequently underperform. This past year, however, ETF Flow had by far its highest return at 1.4%. This shift started in October 2022 and continued its upward trend throughout 2023.
Kevin, Reshma, Jose, and David
The Omega Point Product Specialist Team