When “Quality” Stops Protecting You: Why Factors Must Be Regime-Aware
Why do proven factors fail during market stress? This piece explores regime-aware investing, showing how institutional portfolios switch between Alpha Mode and Survival Mode to reduce drawdowns and improve long-term outcomes.
Most equity strategies are built around a reassuring assumption:
If a factor works over time, it will protect you when markets turn.
In practice, this assumption is one of the most common sources of drawdowns.
What matters is not whether a factor works on average, but when it works — and when it fails. Markets are conditional systems. Signals that create alpha in one environment can actively destroy capital in another.
Our research reinforces a simple but uncomfortable truth:
Factor effectiveness changes dramatically across market regimes.
Ignoring this is not a modelling flaw. It is a design flaw.
The Problem With “Always-On” Factors
Traditional factor models treat signals as permanent truths:
- Quality always works
- Growth always adds alpha
- Institutional ownership implies safety
This logic breaks precisely when it matters most.
In stressed markets:
- Liquidity dominates fundamentals
- Crowding matters more than quality
- Correlations converge
- Selling becomes indiscriminate
A system that refuses to adapt does not fail slowly — it fails suddenly.
What the Evidence Shows
1. Quality Works — Until It Doesn’t
Profitability and efficiency metrics such as ROE and ROCE are often assumed to be defensive.
The evidence shows otherwise.
- In normal market conditions, these factors are persistent and reliable
- During market stress, they fail sharply
The reason is structural:
- High-ROE stocks tend to be crowded
- They are priced for perfection
- When liquidity disappears, they de-rate faster than the market
Implication:
Quality is a return enhancer in calm markets — not a shock absorber in crises.
2. Growth Is Not Just Weak in Stress — It’s Harmful
Growth indicators such as revenue acceleration or margin expansion:
- Perform acceptably in benign environments
- Break down completely during risk-off phases
When markets turn defensive:
- Growth expectations reset
- Near-term balance sheet strength dominates
- High-growth names are often sold hardest
Implication:
Growth signals must be explicitly restricted to risk-seeking environments.
Using them during stress increases drawdowns rather than returns.
3. Promoter Alignment Becomes Crisis Alpha
The most important insight emerges during market stress.
Promoter-related signals:
- Are modest in normal conditions
- Become strongly predictive during drawdowns
When markets turn fearful:
- Institutions de-risk mechanically
- Liquidity providers step away
- Promoters are often the only informed, committed holders left
Stocks where promoters are not selling — or are increasing exposure — consistently hold up better.
Implication:
Promoter alignment is not a growth signal.
It is a survival signal.
4. Institutional Flows Add No Edge
Despite their popularity, institutional holding and flow metrics:
- Show no reliable predictive power
- Are often negative across market regimes
- Tend to reflect past performance rather than future returns
Implication:
These signals create comfort, not alpha.
They are better removed than reweighted.
From Factors to Roles, Not Fixed Weights
The key design shift is this:
Factors should have roles, not permanent weights.
Based on how they behave across environments, factors naturally fall into different categories:
- Core return drivers — effective in normal markets, disabled during stress
- Stabilizers — help balance portfolios across regimes
- Crisis-alpha signals — activated when risk is being punished
- Risk-on signals — explicitly gated to favorable environments
- Removed signals — noise or consistently harmful
This prevents one of the most common systematic errors:
deploying yesterday’s winning signals in today’s market.
Designing for Two Operating Modes
These findings lead to a simple but powerful framework:
- Alpha Mode
Used when markets reward risk.
Quality and selective growth signals are allowed to work. - Survival Mode
Used when markets punish risk.
Capital preservation takes precedence.
Only stress-resilient signals remain active.
The transition between these modes is driven by market conditions, not conviction.
How This Is Implemented in Practice
These insights are not treated as research observations alone. They are embedded directly into the portfolio construction process.
Market regimes are identified using a deterministic, multi-signal framework, with asymmetric thresholds designed to turn defensive faster than they turn aggressive.
Each regime maps to a clearly defined system mode, specifying:
- Which factors are active
- How much capital is deployed
- How much is held in cash
Factors shown to fail during stress are explicitly gated off in risk-off environments, rather than being merely down-weighted. Signals that demonstrate crisis resilience are emphasized.
The same regime signal propagates consistently through scoring, position sizing, and portfolio construction, ensuring that portfolio behavior aligns with the intended system mode.
This eliminates discretionary overrides and reduces the risk of silent model drift.
Why This Matters for Long-Term Outcomes
Most long-term underperformance does not come from:
- Poor research
- Weak factor design
- Lack of sophistication
It comes from failing to adapt when the environment changes.
Portfolios that respect regime-dependent factor behavior:
- Experience smaller drawdowns
- Recover faster
- Preserve capital for future opportunity sets
Closing Thought
Good strategies find alpha.
Durable strategies know when not to chase it.
Markets reward risk in some phases and punish it in others.
A system that recognizes this — and adjusts accordingly — stands a far better chance of surviving full market cycles.
That, ultimately, is what institutional-grade portfolio design is about.