Adage Capital Trailing Stocks Says ‘Smart Beta’ Distorts Market

  • Hedge fund returned 1.1% in fiscal year ending June 30
  • Environment is ’most challenging’ seen in years, letter says

For the first time since it started 15 years ago, Adage Capital Management is trailing the stock market. One reason for the rare underperformance, according to the almost $28 billion hedge fund: The rise of factor-based investing.

Adage Capital, founded by two former money managers at Harvard University’s endowment, gained 1.1 percent in the 12 months ending June 30, according to its quarterly letter, the first underperformance for a fiscal year. The S&P 500 Index returned 4 percent in that period.

The Boston-based hedge fund, which takes long and short positions on stocks, said factor-oriented investing creates a wedge between the price of equities and their fundamental values. The growth of passive investing through products like low-volatility ETFs is crowding out stock pickers, making it difficult for them to trade larger positions. This means more stocks will move with prices set by macroeconomic factors even when there is no overriding macro justification for it, the letter said.

“We are currently in the most challenging environment we have seen in several years partially due to the rise in factor-based investing via products like ‘smart beta’ and factor-based ETFs," according to the letter.

Adage, which was started in 2001 by Phillip Gross and Robert Atchinson, joins a number of well-regarded money managers in posting returns weaker than their historical averages. Jack Meyer, who built a multi-billion-dollar fixed-income hedge fund after more than quadrupling the size of Harvard’s endowment, risks underperforming for the fifth consecutive year.

Adage is responding by reviewing its portfolios for biases and focusing on flows into factor-based ETFs. The firm also said that as a long-term investor it is well-positioned to take advantage of the pricing disparity created by ETFs since values will eventually follow the fundamental worth of stocks. An Adage spokesman declined to comment about the letter.

"Clearly, portfolio construction and risk awareness are more important than ever in this environment," the letter said.

Joshua Ross, one of Adage’s financial analysts, left the firm, the letter said.

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