In a stock market downturn, does a “flight to quality” pay off for institutional investors? Historical research using our StarMine Earnings Quality model confirms the benefits of this approach.
- We examined four market sell-offs using the StarMine Earnings Quality (EQ) stock ranking model as the measure of “quality.”
- Cumulative top decile returns significantly beat the equal-weighted universe in all sample periods.
- Tilting a portfolio to a quality factor or adding it as a filter to new-idea generation screens can greatly improve performance.
In times of fear or uncertainty, institutional investors typically have to maintain market exposure as part of their mandate, but may shift their holdings toward lower-risk securities.
To find out if there is truth in the “flight to quality” adage, we’ve examined several market sell-offs using the StarMine Earnings Quality (EQ) stock ranking model as the measure of “quality.”
Watch: Evidence for titling portfolios toward quality during market downturns
Our test examined the “official” beginning to end of recent bear markets, as well as prolonged corrections when the downturn didn’t descend by 20 percent or more.
StarMine EQ is designed to measure the sustainability of a company’s sources of earnings. It is an enhanced version of the Accrual Anomaly.
We examined the performance of the StarMine Earnings Quality model, starting at the time of the correction, rebalancing the portfolio monthly and excluding transaction costs.
The results were calculated with the backtest capabilities of our QA Point product, developed in partnership with platform developer Elsen Inc.
To capture the correct dates, we turned to economist and strategist Edward Yardeni, whose table of S&P 500 Bear Markets and Corrections since 1928 appears in his new book.
With permission, those since 1998 are shown below.
For our test, we chose the four longest downturns:
- Tech bubble bursts (March 2000-October 2002)
- Sub-prime mortgage crisis and Great Recession (October 2007–March 2009)
- Global market sell-off post downgrade of U.S. sovereign credit rating (April 2011-October 2011)
- China stock market crash (November 2015-February 2016)
Risk mitigation in a market downturn
The results of this test support the hypothesis.
Cumulative top decile returns significantly beat the equal-weighted universe in all sample periods and an absolute-return strategy using top/bottom decile spreads is alpha generative.
Bottom decile, or poor-quality stocks had especially negative returns versus the overall universe.
Filtering out low-quality securities during a market downturn appears to be especially beneficial as a method of risk mitigation, reducing portfolio volatility and improving risk-adjusted returns.
It’s important to note here that spreads are rebalanced and compounded monthly and not just calculated as top decile minus bottom decile.
Flight to quality behavior
The performance of EQ over the entire history sample of January 1998 to March 2018 showed an annualized decile spread of 7.51 percent and a Sharpe Ratio of 0.55 to measure the risk-adjusted return.
During each of these four major corrections, both the annualized decline spreads and Sharpe Ratios were significantly above those performance measures over the entire 1998-2018 history.
The EQ model performed better than average during downturns.
This appears to validate that a flight to quality behavior does occur during market corrections and that investors benefit from a quality tilt in their portfolios during these times.
Earnings quality in global markets
To this point, we have focused on U.S. market data and indices.
This was to both align U.S. data and correction dates with a U.S. index and also because beating the S&P 500 is one of the toughest challenges and competitors for active managers.
However, market downturns in the U.S. are frequently correlated with global sell-offs.
That was the case in each of our four downturn periods, as shown by the negative benchmark and equal-weighted universe returns below.
Correlations of cross-market returns during a major market downturn often increase. This is often referred to as market contagion.
For that reason, and for the benefit of our global asset management community, our study next examines returns using the constituents of the MSCI World index as the benchmark.
Improved portfolio performance
Results are consistent with those run against the S&P 500, with cumulative top decile returns beating the equal-weighted universe in each period and generating consistently strongly positive annualized decile spreads.
These results were achieved with especially good risk-adjusted returns.
Sharpe ratios are quite good in each period. Again, we note the significant degree of underperformance among bottom decile constituents.
We discovered convincing evidence of a “flight to quality” during market downturns and that by tilting a portfolio to a quality factor or adding it as a filter to new-idea generation screens we can greatly improve performance during those times.