We disseminate a report each morning with 3 bulleted takeaways to contextualize our derivatives-centric models and screens. If you're interested in getting it daily shoot me an email back. The point is to hash out observed consensus views with our own to 1) Find asymmetric pressure points and 2) Generate alternative ways to play our macro themes. Below is this morning's note relating to a pocket of the #CyclicalPeaks section of our Q4 Macro Themes presentation.
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There’s obviously a lot of red in macro so we’ll save the individual call-outs. This morning we’re going to contextualize the #CyclicalPeaks section of our Q4 macro themes presentation in a series of charts because we’ve received a lot of inbound on violent style factor rotation. The note is a little lengthy but process oriented which hopefully has a shelf life. Note that the QUAD4 call was a cyclically driven view from our GIP-Modeling process and our work on style factor portfolio constructions and volatility trends were additional layers that confirmed the “surprise factor”.
Chart 1: In an ETF’d style factor universe in the domestic mid/large cap space, we have a mix of active and passive strategies to track performance. In a red market broadly, Growth and Momentum style factor constructions have been hit hardest.
*NOTE* Expanding on a discussion we’ve had lately, part of the reason systematic active strategies have been under pressure of late is that fact that what they are betting to be uncorrelated strategies have not been offsetting in 2018 and the long-term back-testing of “factor premiums” concludes that in general “growth” is a bad factor to own long-term (i.e. 5yr sales growth, 5yr net income CAGR, 2yr forward EPS growth, etc.). That comment is perhaps an over-generalization to make the point on owning "Growth" long-term. “Value” and “Momentum” are typically marketed as 1) uncorrelated with one another; BUT 2) able to outperform a broader market or index on a standalone basis over the long haul (even better if they’re combined in a portfolio) – that’s the marketing pitch.
Again on that first chart you can see that a long-only combination of 50/50 “Value” & “Momentum” is underperforming “Growth” and broader indices by a wide margin YTD. In the more active, pure factor strategies like QMOM and QVAL, performance is worse than style factor indices. If you’d like to discuss details of how those portfolios are built to capture the factor, please reach out.
Chart 2: Back to the 2018 underperformance in popular quant strategies…We show the reality that factor exposures that are typically combined in market-neutral portfolios (i.e. momentum & value) have underperformed 1) growth and 2) the overall market in 2018.
*NOTE* The returns shown in charts 2-4 are market neutral strategies that are 1) Long top quintile & 2) Short bottom quintile within the top 3000 stocks by size that trade in the U.S. So for example, in “Momentum”, you’d be long the top quintile of 12mth returns and short the bottom quintile (worst 12mth returns) for a return of 1.5%. Unfortunately, if this is paired with the market neutral value portfolio which is down -5.2% this year, you’re down over 3% YTD.
Chart 3: It depends how you define “growth” and “Momentum”, but pick your combination and you can see that despite the turbulence w/w, market neutral strategies have actually done very well despite the YTD woes, while the picture in long-only constructions (think “chart 1 above”) of those two factors haven’t made back nearly as much and have actually done worse in some cases despite the fact that “growth” indices/strategies have been clobbered, leading broader indices to the downside. That’s what happens when your combination of Momentum and Value portfolios are higher beta in a market correction which brings us to the next point…
Chart 4: Don’t confuse “value” with “Low-Vol & Yield” which is our preferred exposure in QUAD4. There will be overlap in the stocks of those two portfolios, but if your “value” capture is higher beta/vol, a QUAD4 market environment may not help you out. This environment is about beta-downshifting based on our historical studies of QUAD4 market instances.
Charts 5 & 6: Cyclical Relative Performance; We pull back long-term performance trends to show the outperformance in Momentum, and more importantly with regards to our call: Growth
Chart 7: Sector Risk; Technology sector weightings in “growth” and “momentum” strategies have surged in recent years
Chart 8: Relative 6-12 Mth performance began to slow in “growth” exposures well before Q4 started.
Chart 9: And many “growth” pockets of the market were also picking up relative volatility well in advance of Q4.
*NOTE* Regarding Charts 8 & 9, these two trends create rebalancing risks in tech and growth in momentum portfolios which is why they were call-outs in our themes presentation. A lot of money is managed looking to capture 6-12 month price momentum and many of these strategies have volatility overlays (i.e. Low-Vol Momentum)
Charts 10 & 11: We’re of course seeing this volatility embedded in forward looking expectations. Charts 10 &11 compare the cost to hedge 3-Mths forward at-the-money in Russell 1000 & 2000 Growth vs. Value ETFs (implied volatility ratios). You can see that relative hedging costs in the “growth” indices have skyrocketed. This was a trend long before the month of October began and it was likely driven by the pick-up in relative realized volatility that we mentioned above with “Chart 9” commentary.
Takeaway: #CyclicalPeaks was born out of our view on the economic cycle, and our work in volatility markets and style factor trends provided evidence to the surprise factor embedded in this cyclical framework.
