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Fama/French going through its biggest drawdown since 1963

26 aug 2020

Dear investors,

A while ago we wrote a blogpost on how the Fama/French factors were going through their second biggest drawdown ever [1]. A couple of months and a pandemic later, the bad times for quants have sadly kept on rolling and a multifactor approach to investing has now officially reached its worst streak of relative performance since 1963.

In a way the situation mirrors the years leading up to the dotcom bubble, as value investing (HML) has been hit exceptionally hard over the past decade. This begs the question is value investing dead? Researchers at AQR, one of the biggest quant players in the world, argue value is clearly in a slump but that there is potential for a rebound. The arguments that are generally made by the proponents of growth investing are:

  1. The world is getting increasingly monopolistic, where just a handful of companies with network effects will be the global winners.
  2. The measures used to capture the value effect, like the price-to-book ratio, are too simple and no longer able to capture the value of intangibles and technological advancements.

Following these arguments quants should abolish value metrics from their toolkit and just focus on factors that do work right now – like momentum. Admittedly, taking a neutral stance of the valuation of companies would have lowered the drawdowns quants have experienced over the last couple of years substantially, but avoiding short-term pain should never be an argument to lower an investor’s long-term gain.

And while the arguments made above may have a certain intuitive appeal, value investors would argue that the premium is driven by a net over- and underreaction of the market. This means that, even when the world is getting increasingly monopolistic, the value premium can still work well. All that is required is that people’s expectations about the pricing power and market potential of the Amazons and Tesla’s of the world will – in reality – be a bit worse than expected and that the downbeat sectors and companies will do a bit better than expected in the end. Moreover, on the aspect of technological advancement, one can argue that this time is not different. From the railway era through the space - and internet age, value investing seem to have persisted throughout history.

In the table below you can see how many of the times the Fama/French approach to quant investing added value relative to investing in the broad market. For a one year holding period you can expect to beat the market about 7 out of 10 times over the past 6 decades, which is a much better hit rate than most investors have. As the holding period increases so does your chance to beat the index. In fact, there’s just a 1% chance to have a worse performance than the broad market when you use a quantitative approach to investing for 15 years in a row. But yes – you guessed it – quant investing is going through that very period right now.

 

1Y

3Y

7Y

15Y

% Beating the broad market

71%

84%

93%

99%

% Underperforming the broad market

29%

16%

7%

1%

Yet, after the rain comes sunshine… And while going through a period of relative underperformance is mentally challenging, we argue that quant investors should expect this from time to time - in fact it is necessary in order for the multifactor investing to keep working in the long-run! Moreover, as the graph below goes to show, when quant underperforms it tends to come back with a vengeance, rewarding those investors that have the tenacity to stick with a proven method and punishing those with weak hands…

[1]: If you wish to know more about the construction of the ‘quant’ indices we show today you might want to reread that article as it is explained in more detail here.