Traditional factor models help investors categorize stocks and predict market trends, but unexpected external events—such as tariffs—can disrupt these models. A potential solution is the introduction of a "Tariff Factor," which uses foreign revenue exposure as a proxy for tariff sensitivity.

Investors base their decisions on factors, which are quantitative variables assigned to stocks, often rated on a scale from 1 to 5.

Commonly known factors include growth vs. value, large-cap vs. small-cap, momentum, volatility, etc.

Investors can neutralize their portfolio to reduce exposure to a specific factor.

Alternatively, they can tilt their portfolio to benefit from favorable movements in a particular factor.

Investors also study these factors to make predictions about market trends.

A challenge arises when an external event occurs that is not accounted for by the ten known factors.

For example, events like COVID, Ukraine War, or Tariffs can significantly affect the market, leading to returns driven by factors not represented in the existing models.

In these cases, the factor model may fail to predict market behavior, or a new factor may need to be created to account for the unforeseen event.

For instance, a proxy for the tariff factor could be the percentage of a firm’s revenue that comes from foreign markets. Investors might then adjust their positions by going long, short, or neutral on this factor.

In our previous research, we found that U.S. semiconductor stocks with Chinese factories and the highest foreign sales were among the hardest hit.

Similarly, stocks with the highest import exposure from Chinese U.S. factories also saw the largest declines.

Sector ETFs with the highest proportion of foreign revenue also experienced the steepest losses.

This chart shows the S&P 500 returns based on foreign revenue exposure.

A more precise metric might involve evaluating performance by country rather than by

sector or revenue alone.

Investors should develop tariff-related metrics and incorporate them into their factor models.

Factor models often fail when external shocks, like tariffs, disrupt the market. Investors can adapt by introducing a Tariff Factor based on foreign revenue exposure. This allows for strategic positioning—going long, short, or neutral—depending on tariff-related risks. As past trends indicate, companies with high international exposure often experience the most volatility when tariffs are imposed.

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