In the third quarter of 2020, markets continued their swift recovery from the lows of March. The most volatile stocks led the way, making it especially difficult for the strategy to keep pace. The characteristics of outperforming stocks tended to be higher volatility, strong price momentum, and strong top-line growth. Companies with business models that proved to be pandemic/stay-at-home beneficiaries, mainly found within the consumer discretionary and information technology sectors, also outperformed.
Regional performance was narrow for the quarter overall, with the U.S. and emerging Asian markets outperforming significantly. Cyclical sectors dominated in the third quarter, led by consumer discretionary stocks, which continued to benefit from strength in online retailers. Defensives sectors, such as consumer staples, utilities and health care, lagged in the developing bifurcated cyclical rotation. Factor performance remained narrow and with a few exceptions, was led by growth, price momentum and quality.
There was notable rotation during the September selloff. Regionally, the U.S. market underperformed significantly, weighed down by a significant pullback in U.S. technology and media leaders, while Japan, Europe and emerging markets all outperformed the broader benchmark. On a sector basis, leadership shifted to more defensive sectors, with utilities, health care and consumer staples all outperforming. Factor performance also experienced a significant reversal, with the low volatility factor benefitting from a shift away from momentum and growth stocks.
The U.S. was the most significant detractor in the third quarter, relative to the MSCI ACWI. Information technology and consumer discretionary led the way in a high-volatility market. Japan was the second-worst country for relative contribution, driven by the communication services sector. Emerging markets was the best contributing region, driven by selection within Taiwan. From a sector perspective, selection within communication services and consumer discretionary detracted the most, while information technology selection (driven mainly by Taiwan) was the most additive.
An overweight to lower-volatility stocks detracted from relative performance over the quarter, as the most volatile stocks outperformed during the rally off the market bottom that began at the end of the first quarter. Value factors also continued their underperformance, but showed the beginning of a rebound toward the end of the quarter as high-flying technology sold off. Both quality and price momentum posted strong performance on the quarter.
The current market environment, which is dominated by a concentrated group of mega-cap growth and momentum stocks, continues to challenge the Fund’s investment process and the relative performance of the portfolio. The Fund’s investment process, which consists of a diversified combination of fundamental factors and research processes, coupled with a risk-controlled portfolio construction process, is designed to outperform over a full market cycle. The historically fast rebound of equity markets off the bottom in March has been driven by historically more volatile sectors and companies, which is common for equity market rebounds, and is within the distribution of expected outcomes when exposed to low volatility.
The rapid selloff of many mega-cap growth stocks in September, coupled with the emerging leadership of industrials and materials stocks and strong performance of value factors, provided what the portfolio manager believes is a lens into relative positive performance when the market comes up for air. Although it is unclear what the catalyst for change will be, there are a number of events in progress and on the horizon that could drive improving market breadth and reduce stock and factor correlations.
Significant impacts on performance