This post was written with contributions from Anqi Dong, CFA, CAIA. Anqi is a Research Strategist on the SPDR® Americas Research Team.

After a prolonged period of abnormally low stock market volatility, the appearance of rising inflation and Treasury yields in early February spooked investors, sparking an equity market decline of more than 10%. In a previous blog, I examined this market sell-off through a macroeconomic and investor sentiment lens.

In this blog, I want to look at the sell-off through a smart beta and factor investing lens. This is a useful exercise and a helpful way for investors to work on their smart beta education, as it can compartmentalize behavior and provide insight into performance trends. By comparing February’s market sell off with past market corrections, we can determine how equity factors tend to react to movements in nominal yields and which smart beta factors may help bolster portfolios as interest rates rise. It’s worth pointing out, however, that multiple variables—from macro to fundamental—can impact factor behavior and there is no single smoking gun. Nonetheless, the following analysis could provide insight into why certain factors behaved the way they did during the selloff.

Interest rate movements and stock market corrections

Between 1999 and 2017, the US stock market witnessed six market corrections and two bear markets. A correction is defined as a decline of more than 10% for the S&P 500® Index; a bear market is defined as a drop of 20% or more.

The chart below shows that four of the six market corrections—highlighted in orange—occurred during the periods when 10-year Treasury yields were trending higher ahead of the selloff. This is similar to the environment we witnessed during February’s stock market sell-off.

Stock Market Corrections During Rising and Falling Rates
Source: Bloomberg Finance L.P., as of 2/26/2018

Smart beta factor performance during equity market sell-offs: The past and the present

When markets sold off in February, all smart beta factors posted negative returns on an absolute basis. But investors’ “flight to safety” reaction meant that the low volatility and dividend yield factors outperformed the broad market by 65 basis points (bps) and 28 bps, respectively, given their overweight to defensive sectors such as utilities and telecom.1

This factor performance during market sell offs is consistent with historical trends. The chart below shows how defensive factors (such as low volatility, dividend yield and quality) performed better than more risk-on factors during corrections or bear markets. However, if we look at corrections in a rising interest rate environment (the beige bar in the following chart), the outperformance of defensive factors was less significant, meaning they provided less of a cushion to investors during market corrections that featured rising yields.

Source: FactSet, as of 2/26/2018. MSCI USA Minimum Volatility, MSCI USA Enhanced Value, MSCI USA Quality, MSCI USA Equal Weighted, MSCI USA High Dividend Yield and MSCI USA Momentum indices are used to represent the factor performance.

Analyzing smart beta factor performance after a market sell-off

Now let’s look at a different time horizon. If we study factor performance six months after a market sell-off, we find it exhibits a risk-on tone. Based on the historical average performance, the next chart demonstrates that risk-on factors—such as value and size—outperformed the market by a significant amount, while low volatility and dividend yield lagged.

However, this chart also shows the outperformance of value and size is less significant in a rising interest rate environment. Meanwhile, dividend yield held steady in a declining rate environment as investors looked for bond alternatives to generate income.

Source: FactSet, as of 2/23/2018. For the periods from 1/1/1999 – 12/31/2017. MSCI USA Minimum Volatility, MSCI USA Enhanced Value, MSCI USA Quality, MSCI USA Equal Weighted, MSCI USA High Dividend Yield and MSCI USA Momentum indices are used to represent the factor performance. Excess returns are calculated based on the MSCI USA Index.


Factor performance during a cycle of monetary tightening

Using the chart below, we can view factor performance through the lens of monetary policy and not just a rise in long term rates. This scenario dissects when borrowing rates are being physically moved higher based on prevailing macro conditions. It shows the majority of factors underperformed during interest rate hike periods relative to when no rate hikes were being instituted, with the exception of momentum.

As stated earlier, factor performance can be impacted by multiple variables, and providing attribution as to why one factor did well while others lagged can be a difficult task. Based on the analysis here, holding other variables constant and using interest rate trends as an explanatory variable. One possible explanation for momentum’s outperformance could be that periods of rising policy rates coincide with a late cycle market featuring low volatility and sustained market trends, which may benefit trend-following strategies, such as momentum. In addition, low volatility and dividend yield likely underperformed the broad market during rate hike cycles due to their concentration in bond proxy stocks, which are less attractive than bonds with higher yields. The underperformance of size and value may be tied to their higher financial leverage because rising interest rates create more financial stress on companies with heavier debt levels—two common traits of companies within those styles. 

Source: FactSet, as of 2/23/2018. For the periods from 1/1/1999 – 2/23/2018. Rising rate period is defined when target Federal Funds Rates are increasing. Rate hike periods include 6/1/99 – 7/31/00, 6/1/04 – 7/31/06 and 12/1/15 to current. No rate hike periods include 8/1/00 – 5/31/04 and 8/1/06 – 11/30/15.

Look beyond single-factor low volatility strategies to navigate rising interest rates

February’s drastic market sell off brought investors’ attention back to managing stock market volatility and could trigger a rush to the low volatility factor. However, the charts above illustrate the differing behavior single factor strategies exhibit depending on movements in interest rates.

Meanwhile, as we are currently transitioning to more normal monetary policy, investors should expect more bouts of episodic market volatility. Single factors will have their ups and downs, and a diversified factor exposure may provide a smoother ride and capture sufficient upside.

Given this, investors can consider equity allocations that seek to minimize volatility, while also offering exposure to other factors—like value and quality—for a more balanced and diversified exposure. This approach may reduce risk and provide a lower beta, while maintaining better potential upside capture than single-factor low volatility strategies.

To keep up-to-date on the evolving market environment after the market sell-off, be sure to follow SPDR Blog and check back for our latest insights.

1FactSet, as of 2/26/2018


Measures the volatility of a security or portfolio in relation to the market, usually as measured by the S&P 500 Index. A beta of 1 indicates the security will move with the market. A beta of 1.3 means the security is expected to be 30% more volatile than the market, while a beta of 0.8 means the security is expected to be 20% less volatile than the market.

Low Volatility Stocks 
A category of stocks that are characterized by relatively less movement in share price than many other equities.

MSCI USA Enhanced Value Index 
The MSCI USA Enhanced Value Index captures large- and mid-cap representation across the US equity markets exhibiting overall value style characteristics.

MSCI USA Equal Weighted Index 
Represents large- and mid-cap securities in the US market. At each quarterly rebalance date, all index constituents are weighted equally, effectively removing the influence of each constituent’s current price (high or low). 

MSCI USA High Dividend Yield Index 
Includes large- and mid-cap stocks in the US Market. The index is designed to reflect the performance of equities in the parent index (excluding REITs) with higher dividend income and quality characteristics than average dividend yields that are both sustainable and persistent.  

The MSCI USA Index aims to measure the performance of the large and mid-cap segments of the US market. 

MSCI USA Minimum Volatility Index
The MSCI USA Minimum Volatility (USD) Index aims to reflect the performance characteristics of a minimum variance strategy applied to the large- and mid-cap US equity universe. 

MSCI USA Momentum Index
The MSCI USA Momentum Index is based on MSCI USA Index, its parent index, which captures large- and mid-cap stocks of the US market. It is designed to reflect the performance of an equity momentum strategy by emphasizing stocks with high price momentum, while maintaining reasonably high trading liquidity, investment capacity and moderate index turnover.

MSCI USA Quality Index
Includes large- and mid-cap stocks in the US equity market. The index aims to capture the performance of quality growth stocks by identifying stocks with high quality scores based on three main fundamental variables: high return on equity (ROE), stable year over year earnings growth and low financial leverage. 

S&P 500 Index
The S&P 500, or the Standard & Poor’s 500, is an index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ. The S&P 500 index components and their weightings are determined by S&P Dow Jones Indices.

Smart Beta
Smart beta defines a set of investment strategies that use alternative index construction rules to achieve outperformance over first-generation market capitalization based indices. Smart beta indices isolate six particular “factors”—small size, value, high yield, low volatility, quality and momentum—and are designed to deliver better risk-adjusted returns than cap-weighted indices.