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Are factor premia disappearing?
14 jun 2019
After four consecutive months of gains a bearish sentiment seems to enthral the equity markets once more. As a result of the US tariff increase on imports from China stock markets ended May significantly lower, with losses ranging from just 3.4% in Japan to 8.3% in Emerging Asia. The USA was hit just half a percentage point worse than the global index that fell by 5.4% during the month.
On a Long/Short basis both Momentum (+7.7%) and Quality (+3.3%) did what they tend to do: outperform in downward markets. Value (-6.1%) on the other hand was hit especially hard during the month. While most investors know that value has underperformed growth for quite some time now, it is less common knowledge that most ‘well-known’ factors have pretty much stopped working since 2015. To illustrate this point, you only need to look at the five factor families’ performance below, as calculated by a large international bank. With a performance that is nearly flat before all costs it is no wonder why most quants have struggled over the past 4 years.
While the graph makes a good argument for combining factors, as the model outperformed every individual family, it is clear that when none of the factors really work any quantitative model will suffer. Much like the experience we had at Vector, 2016 and 2018 were painful years for quants, while 2017 was a very sound year.
With the rise in popularity of factor investing you could hypothesize that the quant space has become overcrowded, which would ultimately cause the alpha of these strategies to drop - much like we have seen over the past 5 years... Yet, the December 2018 study “Characteristics of Mutual Fund Portfolios: Where are the value funds?” provides evidence to the contrary. The authors of this paper provide empirical evidence that actually neither mutual fund managers or ETFs systematically tilt their portfolios towards well-known factor families. In fact, funds often take opposite legs of a trade: there are many value ETFs that like to buy cheap stocks, but likewise there are many growth funds that aim to find the next Amazon. In other words, these two groups of investors are essentially betting against each other, which makes it quite unlikely that factor premia will disappear any time soon. Good news for us!
Vector Navigator fell by 5.02% in April, bringing its year to date result to 9.74%. Vector Flexible, which had hedged a significant portion of the market risk, fell by just 2.37% during the month. Thus, all-in-all our funds had a decent month in terms of relative performance compared with their respective benchmarks.
Werner, Thierry & Nils