Does the Economy Affect Factor Returns?

With all the attention that is paid to macroeconomic variables and forecasted growth, it’s vitally important to understand the role that the economy plays in portfolio returns – in particular, the returns of the value, beta and size factors.

Many investors look to changes in interest rates when making tactical asset allocation decisions, which begs the question: Do changes in interest rates provide explanatory power in the cross-section of stock returns? To answer that question, Dimensional examined the performance of the stock market and the beta, size and value factors based on changes in the federal funds rate as well as one-, five- and 10-year Treasuries. The data sample covered the period August 1954 through December 2018. Following is a summary of their findings:

  • While the realized beta, size, value and profitability premiums have been positive on average, there has been substantial dispersion of their realized returns over time.
  • There has been no discernable pattern in the historical data suggesting that the size, value and profitability premiums behaved differently in months when the effective federal funds rate went up versus when it went down. The same is true when we replace federal funds with one five- and 10-year Treasuries. Thus, interest rate levels have explained almost none of the variation in the size, value and profitability premiums.
  • Over the period 1963 through 2018, the R-squared values (correlations) of the size, value and profitability premiums to interest rate changes have been virtually zero in each case. This indicates there is a lot of “noise” in the relationship.
  • The same pattern of wide dispersion in returns was observed when the value premium was measured against the slope of the yield curve. There was no explanatory power.

Further evidence

In his paper, What Happens to Stocks when Interest Rates Rise? published in the summer 2018 issue of The Journal of Investing, Andrew Berkin found that while the conventional wisdom is that higher interest rates are bad for stocks, the reality is different. He found that over the prior 90 years, interest rates had little predictability for U.S. stock returns. “Whether yields were up or down, stocks did quite well on average. The mean return to the S&P 500 was 10.81% when yields fell and somewhat higher at 12.22% when yields rose.” He found similar results in 22 developed markets. He added: “Stocks have had a wide range of returns both positive and negative during times of rising rates. However, some segments of the market such as high dividend payers have historically lagged when rates rise, and thus do pose potential risks.” And finally, he found no distinguishing pattern between interest rate changes and the value, profitability and investment factors. In the case of small stocks, “results are quite mixed, and often do not conform to the logic that has been given.”