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Quants With $2 Trillion Hit by Correlations at 20-Year High

Justina Lee
·4 min read

(Bloomberg) -- Stock market records are doing little to revive fortunes in factor investing, a $2 trillion corner of the quant world that dissects stocks by attributes like how cheap they look or how fast they’ve risen.

The strategies are failing to live up to their diversification label in an era when recession-spurring lockdowns, rally-inducing stimulus and game-changing vaccines are all moving markets.

Factor correlations have risen to the highest in at least two decades.

In total-return terms, the AQR Equity Market Neutral Fund -- which tries to balance long and short bets across a range of factors to protect against market turmoil -- lost 5.7% last quarter. The Vanguard Market Neutral Fund, which takes a similar approach, has notched months of losses.

“A multi-factor strategy is placing a lot of bets,” said Josh Russell, an analyst at Franklin Templeton Investment Solutions in New York. “If all of these collapse into one unidirectional bet, you really lose your edge.”

It all means investors who once believed that stocks with high dividend yields, for example, will move independently from those with big profit margins are getting confounded again and again.

Take last week. Democratic victories in Georgia renewed hopes for economic stimulus, meaning pandemic favorites like quality and low volatility stocks dropped, bringing the momentum factor -- which was riding these winners -- down too. The value strategy, which buys neglected shares, moved just as fast in the opposite direction.

The good news? Elevated correlations -- which tend to coincide with periods of market stress -- have historically been short-lived. Many quants will be hoping now that as people get vaccinated and economies recover, factors will move to their own beat again and trade on the fundamental rules discovered by academics decades ago.

For now, multi-factor managers must contend with unforgiving synchronicity. While the value-investing faithful got their longed-for comeback as progress on a coronavirus vaccine boosted risk appetite, its resurgence failed to compensate for broad losses across factors including low beta, quality and momentum.

“The impact we’ve witnessed is that these common sources of return are really focused on the outcome of the disease,” said Mani Mahjouri, chief executive officer at Blueshift Asset Management, a quant hedge fund that neutralizes its factor exposures. “The volatility is definitely higher and the diversification benefit has been nullified.”

That’s a far cry from what is supposed to happen. Rather than pay humans to agonize over a company’s sales or future strategy, the quants argue that outperformance boils down to a few trading rules: Winning stocks will keep outperforming as more investors jump on the bandwagon. Shares with strong balance sheets and reliable profits will ultimately win out.

Sure, those ideas won’t work day in and day out but over the long haul, the investing strategy has minted billions regardless of the economic backdrop.

But in Blueshift’s analysis, the pandemic has prompted investors of all stripes to crowd into stay-at-home haven trades, turning them into extreme momentum and low-volatility bets. Meanwhile, Covid-sensitive shares are moving in the opposing direction to notch a strong negative correlation with their defensive peers.

Such herding made those strategies prone to violent drawdowns on good pandemic news and riskier ones like value -- which gains on economic optimism -- to sharp rebounds. After last Wednesday’s election-spurred rotation, for instance, value slumped anew and more defensive factors like quality regained ground. As Treasury yields rose on Tuesday, value rebounded again while quality dropped, Dow Jones market-neutral indexes show. The 60-day volatility of momentum is near its highest since 2009.

Yet it may be wishful thinking to conclude factor investing is misfiring because of the pandemic pure and simple. In a world where these quant strategies are widely known and accessible through exchange-traded funds, there are fears that they have become more prone to crowding and fickle money flows over the years.

All the same, to Bernstein strategists today’s trading regime of extreme correlations may prove the “darkest before dawn.” A post-pandemic world may lower synchronized market gyrations and allow one group of stocks to trade independently of another.

“While the high factor correlation remains an impediment we think that it is likely to fall from current extreme levels,” strategists led by Inigo Fraser Jenkins wrote in a note. “This implies that 2021 is likely to become more promising for stock pickers.”

(Updates to add context on Tuesday trading. A previous version was corrected to show the AQR fund’s performance in total-return terms.)

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