The curious case of cross-country factor momentum

Earlier in the year a short Economics Letter by Christian Fieberg and his collaborators caught my eye. The note identified a strange cross-country persistence of stock market factor performance that I found surprising. It points to a fundamental truth behind factor returns: In the end, factor and style returns are mostly driven by the underlying macro environment.

It is relatively unsurprising to learn that factors like value, size, quality, etc. display momentum in their performance patterns. If value stocks have outperformed in the last year, they will likely continue to outperform in the next couple of months. In my view, this is the product of two drivers.

First, most factors work only in a specific macroeconomic environment (for example when economic growth accelerates). But the economy is slow-moving, so the favourable macro environment persists for a while, creating a persistent favourable environment for some factors but for others.

Second, investors are sheep. Ok, they aren’t sheep but they tend to follow the herd. This herding behaviour means they move their assets into factors and styles that have worked in the past. These flows create excess demand that in itself reinforces the performance of past winners creating an artificial persistence of factor returns.

But now, riddle me this. Fieberg and his colleagues found that the relative performance of factor returns between countries is persistent as well. For example, if value stocks outperformed in the UK by a larger margin than in the US over the last year, then value stocks in the UK are likely to have a larger outperformance than value stocks in the US in the next couple of months as well.

Unlike factor momentum, I don’t think investor flows play much of a role because factor portfolios are either country-specific or global. I find it hard to believe that there are meaningful investor flows moving from the UK to the US to Brazil, etc. chasing the highest possible returns for a factor. I think if you are a value investor and your UK value fund is working, you will hardly move it into a US value fund because it is working a little better there. And if you are invested in a global value fund, you won’t even notice these cross-country differences.

Of course, the fund manager of a global value fund may shift assets from the UK to the US because there are more value stocks with strong return prospects there than in the UK. But that brings me back to the first explanation. Factors show performance persistence because the underlying macro environment is favourable to a specific factor.

Now, let’s assume that factor X works particularly well when economic growth accelerates. Economic growth may accelerate in many countries at the same time, but I guess that in some countries it will accelerate faster than in others. And the relative speed between countries is persistent. If growth has accelerated faster in the UK than in the US in the last year, chances are that it will continue to accelerate more in the next quarter. And this, of course, means that factor X will continue to work better in the UK than in the US.

All of this goes to show, in my view, that stock market factors are expressions of the prevailing economic environment. If you want to be a successful value, quality, small-cap, etc. investor you can’t just be a stock picker analysing individual companies and buying the ones with the best individual fundamentals. You need to understand which macro factors drive your style, and whether the environment will be supportive of this style in the future or not.

This is where some professional fund managers fail, I think. So many of them are pure stock pickers who don’t care about the macro picture or try to pick stocks with little consideration of the macro environment. But if you do that, chances are you will pick a great stock that just won’t perform for years simply because it isn’t the right environment for the stock or the style in general. And then you sit there and underperform for a long time and just don’t understand why the market undervalues the great companies you hold in the portfolio. Or as I previously said, for a stock to perform it needs to have a trigger, not just good fundamentals.