Quant Firm Deploys New Metric for Covid Sensitivity

Los Angeles Capital Management, the $20 billion global quant equity firm, has instituted a new factor to help it measure the sensitivities of stocks to Covid-19 and more accurately model their economic performance around the pandemic.

“We wanted to develop one metric that would measure a portfolio’s beta to Covid,” says Hal Reynolds, the firm’s chief investment officer. “If Covid subsides without a fall recurrence and the economy recovers quickly, we would expect portfolios with high Covid betas to outperform.”

The fund embarked on its project after conducting research into economic behaviours after the Spanish flu pandemic of 1918. Its findings showed that post-pandemic consumer behaviour was not restored until 1923 or 1924—suggesting the effects of today’s pandemic are also unlikely to dissipate quickly.

“If the Covid crisis is extended and the economy recovers more slowly,” says Reynolds, “low Covid-beta stocks will retain their advantage. So that’s the goal.”

LACM runs a ‘dynamic alpha’ global stock selection model. It estimates daily returns on about 9,000 stocks, based on the philosophy that the price of risk is a function of investor preferences and their expectations—as opposed to historic returns.

Its creators are of the view that the pandemic and economic crisis will have four phases. As they see it, these are, chronologically: the onset of disease and closure of the economy; the reopening of the economy; the effective administration of treatments and development of a vaccine; and, ultimately, the rebuilding of employment. In the firm’s view, stocks will behave differently in each of these phases.

“None of us knows how long each of the remaining three phases of the crisis will last, so this is riddled with uncertainty,” says Reynolds. “The sensitivity of companies will change as we move through each phase, so a dynamic, forward-looking metric is required to better understand how these betas, or sensitivities to Covid, are changing.”

Covid beta can also be discerned in four parts, says the firm. The first of these is a regional element, which highlights the fact that different regions of the world, such as Latin America, are more sensitive to the pandemic than others. The second is an industry component, which distinguishes industries, such as energy, that are more negatively sensitive to the pandemic than, say, technology or healthcare. The third element identifies transitory effects—those unique to the current environment—as they impact companies whose revenue, profits and prospects are far more damaged than others’. And the final component represents common factor effects. These include, for example, assumptions that highly leveraged companies are at much greater risk in a pandemic than companies that have very strong balance sheets and are therefore better placed to weather a prolonged economic downturn.

The beta factor

The firm also employs a principal components analysis—a statistical technique to estimate the Covid-beta factor return—which enables it to calculate the covariance of the factor with each stock’s excess return.

“We simply say the first principal component is Covid,” says Reynolds. “That is the most important systematic factor. And that captures the aggregate of regional effects, industry effects, common factor effects and transitory effects.”

The betas are updated daily, based on the prior rolling 20 days, to better understand how any given stock’s Covid beta is changing.

Since inception on February 19, the Covid beta has had a standard deviation of 38%. “A staggering number,” says Reynolds. “The high level of risk from Covid is unprecedented. Industry risks are typically 8% to 10%, and common factor risks are lower. Never before have we seen an extra market statistical factor that had that kind of risk,” he adds.

In the weeks leading up to this article, Covid beta has had a modest recovery—taking encouragement from central banks’ move to anchor fixed-income markets, combined with optimism about economies reopening and, not least, the prospects for a vaccine.

As at the end of May, high Covid-beta stocks were outperforming others. Airlines, for example, experienced a significant boost. But, according to Reynolds, full economic recovery is unlikely until the two-thirds of the population unable to work from home are back at work.

“It’s our view that, despite the market’s strong rebound in April and May, Covid-beta risk is still extreme—not quite as high as it was in March, but it’s still over 30%, so we’re going to continue to monitor that,” he says.

At the time of writing, LACM’s models were maintaining a very strong bias towards high-quality balance sheets while avoiding those laden with debt—specifically investment-grade debt, now priced as junk debt—and the energy sector.