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Quants are making money on factor trades like in the good old days.

The firm now recommends a more defensive version of the value trade, such as buying stocks with high dividends and free-cash-flow yields.

September 20, 2022
8 minutes
minute read

The worst year for stocks in a decade is providing a boost for a once-revolutionary breed of quant investor who was dealt a big blow in the cheap-money era.
Factor investing, which involves using machines to identify and invest in stocks based on factors like price or growth rate, is proving to be a profitable strategy in the current market conditions, while more traditional approaches like discretionary hedge funds and day trading are struggling.

As interest rates rise and inflation increases, the leadership of Big Tech is coming to an end. The extreme conditions of the pandemic are reversing, and mega-capitalized companies are no longer seeing the same stock market gains. The performance gap between the winners and losers in the S&P 500 has jumped to the highest level in more than a decade, according to S&P Global data.

This is good news for rules-based managers, who tend to diversify their investments. Strategies that focus on low-volatility or high-momentum companies are doing well, and value shares (those with low prices relative to some fundamental indicator like earnings) are continuing their post-lockdown recovery.
The five most popular factor styles - value, momentum, quality, size and low volatility - have all made money in 2022, according to the Dow Jones market-neutral indexes. The AQR Equity Market Neutral Fund - a long-short product that employs multiple factors - is up 15%.

Despite the stock market rout this year, many long-only factor strategies are still outperforming the broader market. One long-only index from Research Affiliates comprising five factors is outperforming the benchmark by the most since 2004, though it remains negative for the year.
Eugene Barbaneagra, a portfolio manager at SEI Investments Co., said that after years of drought, multiple drivers are now causing positive outcomes.
        "When it rains, it pours," he said.

It's still early, but there are some positive signs for investors who are betting that the end of the low-rate era will lead to extended periods of outperformance for the factor investing industry, which is worth trillions of dollars.
Megacap stocks like Meta Platforms Inc. and Alphabet Inc. have been hit the hardest in the recent selloff spurred by rising interest rates. The regular cap-weighted S&P 500 is on track for its worst year relative to the equal-weighted S&P 500 since 2013.

Quants generally allocate to a broad slate of shares rather than investing in any particular stock or industry, so the more diversified performance in the market is good news for them. This is because their investment philosophy is based on diversification rather than picking individual stocks or sectors.
Bruno Taillardat, head of smart beta and factor investing at Amundi SA, believes that the equity market is better diversified and less concentrated in a few names than it was in the past. He sees this as an opportunity for investors to capitalize on.

According to a Dow Jones market-neutral index, value stocks are up 48% from their 2020 trough. With interest rates on the rise, shares with lower price-to-earnings ratios are looking less attractive. Energy companies, which are favored by long-only value investors, have been the biggest winners in inflationary markets.
This year, the S&P 500 is down 18%. As a result, the momentum trade (buying recent winners and selling losers) has been doing well, as it has been piggybacking on the outperformance of value stocks. Exxon Mobil Corp is an example of a cheap stock that has been doing well recently. The price movements of value and momentum stocks have been closely linked for most of the past two decades, and they are now closer than ever.

There has been a sharp increase in the correlation between different factors as they have all risen together.
According to data from the Dow Jones market-neutral indexes, there is a strong correlation between stock prices and market performance over a 40-day period. This suggests that the market is a good predictor of short-term stock price movements.

The strategy of buying the least-volatile stocks is making a comeback as a refuge from the equity storm. A market-neutral index for the trade is set for the best year since 2018, meaning that value and low volatility are at the highest correlation since 2006.

The high level of co-movement between these factors suggests that they could all fall together if there is another market regime shift. Mark Diver, a strategist at Sanford C. Bernstein, warns that cheap stocks typically underperform in a recession, which is looking increasingly likely. The firm now recommends a more defensive version of the value trade, such as buying stocks with high dividends and free-cash-flow yields.

At PGIM Quantitative Solutions, which manages $91.5 billion, Stacie Mintz says the firm's stock funds now have a lower value tilt after the factor's epic rebound. Yet she remains optimistic about an extended recovery, given cheap shares are still trading near the widest discount ever to growth peers.
She noted that there is still a long way to go before reaching the desired goal.

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John Liu
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