Hedge Fund Momentum Trade Blows Up With Losses Worst Since 2009by
Market neutral quants see largest quarterly drop since 2012
Bets against low-momentum backfire as most-shorted names rise
One of the most popular hedge fund trades just hit a wall.
An investment approach that profits from the divergent paths of high- and low- momentum stocks over time, a strategy that had one of its biggest gains on record in 2015, seized up in the last three months, posting the worst quarter in six years. The plunge helped zap returns among a big category of quantitative hedge funds, the so-called market neutral group, whose year-to-date decline of 2.3 percent is the largest since 2012.
While the tactic may be esoteric, the force that pummeled it is not: a growing revulsion among investors to shares whose main claim to fame in the past few years was that they kept going up. Anyone pursuing the strategy got into particular trouble shorting companies with the lowest price momentum, a section of the market that ended up being the quarter’s biggest winner.
“Momentum was the dominant factor really significantly last year, more so than I can recall any time in my career. When market neutral performs like that, when it breaks, it breaks hard,” said Benjamin Dunn, president of Alpha Theory Advisors, which works with hedge funds overseeing about $6 billion. “All the returns to momentum that were generated, you saw that reverse this year.”
Anacor Pharmaceuticals Inc., whose 250 percent rally in 2015 made it one of the biggest momentum darlings, has plunged 53 percent year-to-date. Activision Blizzard Inc., up 92 percent in 2015, saw valuations peak at the highest in almost six years high on Dec. 31. Shares have since tumbled 13 percent, the video game-maker’s worst quarterly performance since June 2010. Swoons in J2 Global Inc., Tesoro Corp. and Expedia Inc. also punished longs.
At the same time, bets against low-momentum stocks backfired at an almost unprecedented rate, with shorted shares advancing 11 percent in March for its best monthly return since 2011. Harley Davidson Inc., the eighth most-shorted stock in the measure at the start of the year, posted a 13 percent gain over the three months. Range Resource Corp., the third most shorted, had it’s best quarter in over a decade.
“Being short those names was a really good trade during the second half of 2015. This is the flip side of that,” said Pravit Chintawongvanich, head derivatives strategist at Macro Risk Advisors. “All these names which had been doing really bad have turned around and started performing. I would say a lot of it is people getting short squeezed.”
The extent of the wreckage depends on which measure you use. A Dow Jones index tracking the 200 highest-momentum stocks while betting against the 200 lowest dropped 8.1 percent in the first three months of 2016, the most since 2009. By JPMorgan & Chase Co.’s account, momentum long-short fell 20 percent this year through mid-March, a rupture comparable to the “quant meltdown” of August 2007, when the unwinding of crowded trades clobbered equity hedge funds and seeped into the broader market.
Less open to debate is the strategy’s popularity -- a herding effect that some analysts say doomed it to blow up. Hedge funds increased their exposure to momentum stocks in every quarter of 2015, making it the second most popular style after expected growth, data compiled by Evercore ISI show.
On the long leg of the trade, valuations had become stretched. The Dow Jones Long Momentum index P/E ratio was 27.2 heading into the new year, 16 percent above the four-year average. Likewise, investors became weary of expensive shares after the selloff this year, causing momentum stocks to miss out on the S&P 500’s 6.6 percent March rally, said Abhra Banerji, the director of quantitative research at Evercore ISI. Price momentum shares fell 4.3 percent over the same period, according to a portfolio compiled by the banking advisory firm.
“The thing about valuations is that they can be stretched for a very long time, and then something will act as the trigger. In this case, it took a bunch of little things,” Banerji said. “People realized that the cheap stuff had been beaten down too far to no longer be attractive. People had become skeptical of valuations and a lot more skeptical of a lot more growth stocks.”
One cause of the momentum breakdown was “mean reversion,” according to JPMorgan strategist Marko Kolanovic, who predicted in January investors would rotate into value assets, seeking out shares priced at deep discounts to things like earnings and assets. Using long-short proxies, value beat momentum by 40 percent this year, buoyed by systematic strategies covering short positions, Kolanovic said in a March 17 note to clients.
That turnaround may have roiled returns for hedge funds. While they were snapping up the best-performing stocks, hedge funds also reduced value stock holdings in every quarter of last year, making it the least popular of the 10 styles tracked by Evercore ISI.
“Hedge funds and institutions by construction are positively exposed to expected growth and price momentum, which have not been doing well at all and are negatively exposed to value which is doing well,” Banerji said. “I don’t imagine that the performance of hedge funds and institutions has been good in this quarter.”
Still, this rotation is neither unusual nor unhealthy, said Banerji. It keeps valuations in check and resets performance expectations, he said. Momentum and value shares have rebalanced four times since 2006, with the last occurrence in 2013 lasting three months, according to Evercore.
“I’ve heard the same things before. There becomes a prevailing wisdom that value has lost its way, that valuation metrics have lost their way. Yet time and time again, the valuation you pay for a company relative to the cash flow it’s generating is as timeless as a great Sinatra song,” said David Sowerby, a portfolio manager at Loomis Sayles & Co. “It lends itself to longer term sustainable returns than the short term momentum game.”