Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Is factor investing dying?
Peter Garnry
Chief Investment Strategist
Summary: In 2018 we presented the idea that the momentum factor was dead showing evidence from Fama-French data. A month ago a new paper suggests that the momentum factor is experiencing severe crowding effects detriment to the factor's alpha generation. We believe this destiny is now hitting all factors including the beloved value factor. Investors are entering new waters were new methods have to be invented in order to survive. For the retail investor we propose a shift away from momentum, value, quality etc. and want investors to think about themes. In this game the human actual has a chance against the machine.
Back in October 2018 we raised the issue that the famous momentum strategy had potentially hit the point where it was arbitraged away due to more computing power and a wave of funds and ETFs utilizing the momentum factor. We highlighted the AQR Large Cap Momentum Style Fund and its failure to beat the S&P 500. Our main point back then and even more so today is that simple strategies will be arbitraged away.
Adding support for our view a January 2020 paper by Bouchaud et. al. Zooming In on Equity Factor Crowding argues that crowding effects are now very visible in Fama-French factors such as the momentum. The abstract says:
Crowding is most likely an important factor in the deterioration of strategy performance, the increase of trading costs and the development of systemic risk. We study the imprints of crowding on both anonymous market data and a large database of metaorders from institutional investors in the U.S. equity market. We propose direct metrics of crowding that capture the presence of investors contemporaneously trading the same stock in the same direction by looking at fluctuations of the imbalances of trades executed on the market. We identify significant signs of crowding in well known equity signals, such as Fama-French factors and especially Momentum. We show that the rebalancing of a Momentum portfolio can explain between 1-2% of order flow, and that this percentage has been significantly increasing in recent years.
In a Tweet thread yesterday we proposed that the value factor is also dead. Our main point is that the market has become so efficient now that no one-dimensional feature set can any longer produce alpha. The amount of computing power available and access to fundamental data and methodology agreement on what is the value factor on top of many funds and ETFs using the value factor has eroded the signal. The chart below shows the 5-year rolling mean monthly return between value and growth stocks. Since the financial crisis in 2008 value investors have been in one long pain trade due to massive underperformance by financials and energy stocks.
Even Research Affiliates’ attempt to rectify and enhance the value factor by capitalizing intangible assets will save the future for the value factor. It’s still one-dimensional and our hypothesis is that the market is now efficiently pricing growth differentials more or less accurately. In other words, the valuation differences do no longer represent mispricing but approximately correct assessment of future growth. The approximation is what leads to volatility in the factor signal but importantly the volatility represents noise that cannot accurately be captured by timing models.
So what is the future for factor investing? Well the obvious thing that comes to mind is blending multiple factors. This can be done in many ways, but the current version in US equity markets by iShares is not doing very well against the S&P 500 either on returns or downside characteristics. The underperformance has been 2.7% annualized since May 2015. But again if single factors are getting arbitraged away why would a mix of them work?
The edge in quantitative strategies lie in alternative (unstructured) and high quality datasets. With time these will be arbitraged away but not anytime soon. For investors thinking what do next our view is that retail investors with a longer time horizon than below a month should think in themes. Our recent “green stocks” theme is one way to identify interesting stocks that can give an edge over the long run a playground not suitable for machines.
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