Bad Dream Comes True for Quants as Momentum Trade Goes Low BetaBy
Momentum and low-volatility trade begin to deteriorate
Additonal factors creep into single-factor smart-beta ETFs
A bad quarter for automated managers is an example of what can happen when the lines blur around one of today’s hot-button investment themes: factors.
Only about a quarter of quantitative equity funds have beaten their benchmarks since June, reversing a trend from the first half of 2016, research from JPMorgan Chase & Co. showed yesterday. One reason for the skid: managers chasing momentum shares paid a price when a lot of them got caught in the downdraft that befell low-volatility equities starting in June.
While it’s a distinction that sounds like it could only matter to data scientists, the issue is potentially a lesson for the millions of investors who have fallen in love with smart-beta ETFs in the last few years. Portfolios advertised as a way of owning one group of equities can sometimes be overrun by stocks with very different characteristics.
“Your average quant is particularity enamored with momentum,” said Abhra Banerji, the director of quantitative research at Evercore ISI. “The guys who are momentum chasers have a good track record, but they’re struggling because of their investment in low vol.”
Factor investing forms the wiring of smart-beta ETFs, and is also a tool of computer-aided traders looking to diversify or make broader market wagers. Similar to smart-beta, which group stocks into indexes based on characteristics such as high dividends or low valuations, quant strategies based on factors might dictate owning companies with common earnings, price or valuation traits, as a way of anticipating market conditions.
According to JPMorgan, automated traders ran into trouble in the third quarter by doing what they often do -- loading up on stocks with the highest price momentum. Turns out, because investors spent the first six months of the year bidding up defensive industries like utilities, many stocks in that group also happened to fall into another factor category, low volatility. When the market turned against low-vol stocks at the start of the quarter, funds holding momentum got burned.
“This unwind of low vol likely explains the recent underperformance of quant funds, while the rotation into value has helped fundamental investors regain some lost ground,” Dubravko Lakos-Bujas, head of equity strategy and global quant research at JPMorgan, wrote in a note to clients Wednesday. “Quant funds fared better in the first half as their performance is more closely tied to low-vol stocks.”
How much these descriptions matter depends on whom you’re talking to -- one person’s “style infection” is just faulty stock picking to someone else. Even so, assembling stocks according to shared style characteristics has been a goldmine for ETF providers. Particularly for people trying to duck in and out of factor ETFs, knowing that your low-volatility portfolio contains a bunch of momentum shares could be useful.
“If you have an inflection point, price momentum unwinding takes place much more quickly than it does in any other factor, and that’s why it should be relevant to the folks that are investing in low vol,” said Banerji. “If the momentum exposure is increasing your risk of a downside move, that defeats the purpose of holding a low-vol ETF.”
The deterioration of the momentum trade has coincided with a pullback in low-volatility shares. A market-neutral strategy that bets on the highest-momentum companies while wagering against the lowest lost 2 percent since the start of July, according to a Bloomberg PORT U.S. equity model drawn from about 2,000 stocks. The momentum trade is on pace for a quarter equally as grim as the one that kicked off 2016, when the strategy saw it’s worst three months since 2009.
Likewise, the PowerShares S&P 500 Low Volatility ETF has fallen more than 1.5 percent since the end of July, on track for its worst quarterly stretch since the aftermath of the August correction. Flows have also begun to weaken. Since the the start of August, BlackRock Inc.’s minimum variance product has seen more than $333 million in outflows, the most ever for a period of that length.
The worst may not be over yet for low-volatility funds, according to Julian Emanuel, executive director of U.S. equity and derivatives strategy at UBS Securities LLC. Valuations for sectors with low-vol characteristics are still stretched and due for a correction should a catalyst appear, such as in increase in interest rates, he said. In a search for safe yield, sectors less susceptible to fluctuations in the economy like utilities have a price-to-earnings ratio that sits 22 percent above its 10-year average.
“They haven’t suffered any of the potential dangers because they’re still hovering near their highs,” Emanuel said by phone. “By definition, if it’s momentum it’s working and you tend not to suffer draw-downs along the way until the momentum reversal finally occurs. This has been a slow-motion train wreck which could become a fast motion train wreck.”