Study Uncovers Shared Risk in Markets, Shifting Investment Approaches

As financial markets become more interconnected, understanding the shared forces that drive these markets could be critical to making informed investment decisions.

A groundbreaking new study from experts at the Wharton School and elsewhere has revealed that price movements of stocks, bonds, and options – three of the most traded financial assets globally – are driven by a shared set of risk factors. This discovery challenges conventional thinking about how these markets function and raises important questions about investment diversification strategies. According to the researchers, these common factors not only explain much of the variation in returns across all three asset classes, but they also outperform traditional market indicators in predicting future returns.

A Common Risk Factor Across Markets

The central finding of the research is the identification of a dominant “common risk factor” that links stocks, corporate bonds, and options, which the study reveals to be the most significant driver of returns in these asset classes. Using advanced statistical techniques, the research team extracted latent factors from individual asset returns and found that this single factor explains a large portion of price movements across all three markets.

What makes this discovery even more striking is the fact that the common risk factors’ Sharpe ratio – a key measure of return relative to risk – is more than twice that of the stock market itself. For investors and analysts, this finding could change how we understand risk across different types of financial assets. The idea that such seemingly diverse asset classes are influenced by a shared factor suggests that the forces shaping financial markets are more interconnected than previously thought.

Why It Matters

The traditional wisdom for managing financial risk has long been diversification – spreading investments across different asset classes like stocks, bonds, and options. The reasoning is simple: if one market underperforms, the others may offer better returns, balancing out risk. But the findings from this study suggest that these asset classes may not be as independent as we think. If stocks, bonds, and options are all driven by the same underlying risk factors, diversification alone may not offer the protection against risk that investors assume.

For instance, imagine an investor who allocates funds across stocks and corporate bonds, believing that these two assets will behave differently enough to reduce overall risk. According to this research, if both markets are being influenced by the same hidden risk factor, that diversification may not be as effective as expected during times of economic stress.

This isn’t to say that diversification is no longer useful – it still plays a key role in managing risk – but it suggests that investors need to dig deeper into the underlying risk factors driving their portfolios. Simply holding different asset classes might not be enough if those assets are affected by the same market conditions.

The Study

The research spans data from 2004 to 2021, covering a wide array of corporate securities: stocks, corporate bonds, and options. To extract the common risk factor, the researchers employed a method known as regressed-PCA (Principal Component Analysis). This approach identifies hidden or “latent” factors that influence asset returns based on their characteristics, such as company size or bond rating. By combining this data across different asset types, they were able to uncover the shared factor that links these markets.

Previous research in financial markets has often focused on factors that are specific to individual asset classes – such as the size or value factors in stocks – but this study took a broader approach. Instead of looking at individual markets in isolation, the researchers sought out factors that are common across stocks, bonds, and options.

This holistic view provides new insights into how different financial markets are more closely intertwined than many had assumed. The key takeaway is clear: the same factor that moves stock prices may also be driving bond yields and options pricing, meaning that these assets may not be as distinct as traditionally believed.

While the study’s focus is on this powerful common risk factor, it also acknowledges the role of smaller, more asset-specific risks. For example, the researchers found that certain factors related to credit risk, liquidity, and volatility continue to influence corporate bonds and options uniquely. However, these smaller factors pale in comparison to the impact of the dominant shared factor.

For instance, in the options market, characteristics like implied volatility – a measure of expected price swings in the underlying stock – still play a significant role in determining returns. Similarly, corporate bonds are affected by credit risk, which measures the likelihood of default by the bond issuer. Yet, these asset-specific factors don’t have nearly the same predictive power as the common factor, suggesting that the bigger market forces driving all three asset classes should be given more attention.

The findings also showed that the common risk factor is closely linked to macroeconomic conditions. Specifically, it correlates strongly with indicators such as economic policy uncertainty, credit spreads (the difference in yield between corporate bonds and government securities), and financial market volatility (as measured by the VIX index). This suggests that broader economic trends are a key driver behind this shared risk factor.

The Macro Connection: Linking Markets to the Economy

One of the most interesting aspects of this study is the link between the common risk factor and broader economic conditions. The research highlights a close relationship between this shared factor and major macroeconomic variables, including industrial production, inflation, and financial market uncertainty.

For example, the researchers found that this common risk factor tends to spike during periods of economic turmoil – such as the 2008 financial crisis and the COVID-19 pandemic lockdowns in 2020 – when uncertainty is at its highest. This makes sense, as periods of economic instability often affect all financial markets, creating systemic risks that cut across asset classes.

The study also found strong correlations between the common risk factor and measures of liquidity in financial markets, particularly the capital available to financial intermediaries like banks. In times of financial stress, when liquidity dries up, the common risk factor becomes more pronounced, affecting stocks, bonds, and options alike. This suggests that the common factor may reflect broader liquidity risk, which impacts the ability of financial institutions to operate smoothly during crises.

Too Simplistic?

While this research offers new insights into how financial markets function, not everyone is on board with the conclusions. Critics argue that the focus on a common risk factor may oversimplify the complex and often unpredictable nature of global financial markets which are driven by a wide variety of factors that are mostly unquantifiableand unpredictable.

For example, some economists warn that relying on historical data to predict future market movements can be risky, particularly given the unique and unprecedented challenges that today’s global economy faces. Political events, technological innovations, and environmental risks are all factors that may not be fully captured by the common risk factor identified in this study. These outliers could lead to sudden market shifts that catch investors off guard, especially if they’ve over-relied on models that don’t account for these variables.

Furthermore, as the global financial system becomes more interconnected, critics argue that new risk factors could emerge that won’t be explained by traditional models. For instance, the rise of digital currencies, shifts in geopolitical power, or rapid changes in climate policy could all introduce new risks that defy current predictions. In this sense, while the discovery of a common risk factor is important, it’s not a silver bullet for understanding market behaviour.

What Next?

The findings of this study suggest a more nuanced approach to risk management is needed. Investors should be aware that the traditional boundaries between asset classes may not be as firm as once thought. As financial markets become more interconnected, understanding the shared forces that drive these markets could be critical to making informed investment decisions.

However, the complexity of modern markets means that investors should be cautious about relying too heavily on any one model or theory. As the contrarian perspective reminds us, financial markets are influenced by a wide range of factors, many of which are unpredictable and not easily captured by existing models.

As global markets continue to evolve, further research is likely to uncover even more about how these risk factors operate and interact. For now, this study provides a valuable new lens through which investors, economists, and policymakers can view the intricate and interconnected world of financial markets.

Find the research paper here.