How a Market Slowdown Affects Risk Models

This blog was first featured on the Wells Fargo Asset Management blog on March 24th, 2020.

The rapid spread and wide-felt human and economic impact of the novel coronavirus (COVID-19) have continued to roil global equity markets. The chart below plots factor performance since the market began pulling back on February 19. Low volatility continues to be the best-performing factor by a wide margin, with the majority of the other factors underperforming.

Cummulative Factor Payoff

As the market has rapidly evolved, fundamental risk models have failed to adapt to changes in the risk regime, as we highlighted in our last update. In contrast, Analytic Investors’ risk model, which incorporates forward-looking measures such as changes in implied volatility, news sentiment, credit default spreads, and ESG scores, has rapidly adapted.

The chart below plots the risk forecast by industry at two points in time. The teal line represents the Barra risk forecasts on March 6 and March 20, whereas the Analytic risk model is plotted in gold on March 6 and purple on March 20. As is clear, the Barra risk model continues to maintain similar risk forecasts while the Analytic model is rapidly adjusting to current market conditions. In particular, note the large increase in industry volatility for the energy sector as oil prices have rapidly fallen.

Industry Volatility Forecast

Outsized changes in risk aren’t limited to the obviously affected industries like airlines, hotels, and restaurants. While these industries experienced rapid increases in risk during the initial phases of the outbreak, as the coronavirus-induced slowdown begins to cut more deeply, other industries such as metals, communications equipment, and diversified financials are showing significantly increased levels of risk. Even among traditionally low-risk industries, automobiles, consumer durables, chemicals, and metals have seen large increases in their forecasted volatility while food staples, household products, and communication services have had only slight increases in risk.

We believe it’s important to use a model that adapts to current conditions, as ours does, especially during times of high market volatility. This type of modeling—delivering up-to-date snapshots of the risk environment in different industries—provides important and timely information to consider when making investment decisions.

Read our recent blog post, The Why Downside Protection Is So Important >