Fruitful Factors in Recent Recessions: An Empirical Investigation of How Common Equity Factors are Affected by Recessions

Abstract

This thesis sets out to investigate whether the eight common equity factors MKT, SMB, HML, RMW, CMA, MOM, QMJ, and BAB in the period from 1995 to 2021 are systematically affected by NBER-dated recessions characterized by spikes in volatility and illiquidity. The results show that these equity factors are indeed affected in four different ways, namely in terms of return distributions, explanatory power, alpha generation, and investor utility under aversion to recession-related risk elements. Initial investigations show that return distributions are altered during recessions where especially the variance increases. By using OLS, SIC, LASSO, decision trees and random forest, this thesis determines that importance of equity factors in explaining the cross section of return is not constant but depends on market conditions. This contributes to understanding factor models in a dynamic rather than static context with implications for all users of factor models. Alpha generation under the different market conditions proves to be highly factor dependent. BAB and MOM generate the highest alpha during expansions but entail notorious crash risk and exhibit drastic drops to negative alpha generation during recessions. QMJ and RMW, on the other hand, deliver a moderately positive alpha during expansions but more than double their alpha during recessions. CMA also delivers positive alpha during expansions, but alpha is zero during recessions. A similar grouping of factors arises when looking at utility maximizing investors subject to risk aversion, loss aversion and tail-risk aversion that properly capture the characteristics prevalent for factor returns during recessions. A risk neutral investor prefers BAB because it has the highest return of all factors. Increasing aversion to any of the three risk elements, eventually leads to a switch in preference to RMW or QMJ and for even higher levels of aversion, CMA. Only a truly risk loving investor with concave preferences optimally invests in the MOM factor. Investors can utilize the findings on alpha generation and sensitivities to recession-related risks to optimize their factor investments.