Written by: Yazann Romahi and Garrett Norman
Themes from the quarterly Quantitative Beta Research Summit
- Equity factor performance was consistent with trends from 2017, as both equity value and equity size extended drawdowns over the quarter.
- Merger arbitrage suffered amid dramatically more volatile markets, but our expanded suite of event-driven factors posted gains in March, closing the quarter in a strong position and largely offsetting losses from January.
- Macro momentum factors struggled as several markets reversed over the quarter. Carry factors were positive, albeit minimally.
- We believe in diversifying across a broad range of compensated factors while minimizing exposure to uncompensated risks as we move through the latter part of the economic cycle.
Most of the factors that we favor suffered in a quarter singed by a violent shift in volatility regimes. Despite still-healthy economic growth, equity markets moved rapidly from a rally that was deemed both “euphoric” and a “melt-up” straight into correction territory. The shift occurred amid inflation fears and a technical sell-off that saw the CBOE Volatility Index (VIX) experience its largest-ever single-day spike. Additionally, U.S. Treasury yields increased by more than 50 basis points (bps) intra-quarter, reflecting both concerns about inflation and hawkish Federal Reserve rhetoric. Late in the quarter, those gains were reversed. A broad range of factors sold off over this period, across both asset classes and styles, with diversification providing limited benefits (Exhibit 1). On closer examination, however, the decline across factors was asynchronous and behavior was markedly different from that in earlier periods of factor crowding, such as the Quant Crisis of 2007. (We explore this subject in our March 2018 white paper, “Far from the Madding Crowd: Factor Investing Through the Cycle”.)
FACTORS IN FOCUS
Equity factors: A reprise of themes from 2017
Broader trends from 2017 echoed in the first quarter despite the significant rise in equity market volatility. The value factor, in the midst of its fourth worst drawdown since 1990, extended its losses to over 10% from the beginning of 2017. Last quarter we noted the recent short-term increase in linkage between rates markets and value, which reached extreme levels by the end of 2017 (92nd percentile). In Q1 this relationship reverted to normal levels as earnings growth accelerated across growth/expensive stocks on the back of U.S. tax reform. The size factor again detracted, though there were signs of a recovery in March, particularly in the U.S., where 2017 losses were centered. Momentum was positive, despite the backlash against the technology sector and a subset of mega cap tech names in particular, as was quality. (Note: Our momentum factor is constructed on a sector neutral basis.)
Size remains an attractive opportunity, with valuations for the smallest quartile of global developed stocks looking cheap relative to their larger cap counterparts vs. history dating back to 1990 (76th percentile). Quality continues to appear rich from a factor valuation perspective; however, we saw increased dispersion, or difference, in profitability ratios across stocks in our universe, which historically signals a greater opportunity set for the quality factor. While the value factor appears only slightly cheap, it is important to note that value has returned around 5% on an annualized basis (net of assumed transaction costs) dating back to 1990, so it may be poised for similar (or better) performance now that valuation metrics have returned to slightly better than neutral levels. Since the beginning of 2017, expensive stocks have increased in price by 28% (vs. 18% for cheap stocks), while forward P/E ratios have risen by only 4% (from 25.8 to 26.8) (Exhibit 2). While earnings growth has justified a portion of the outperformance of growth stocks, forward earnings estimates are elevated for growth stocks when compared with their historical average (Exhibit 3). Rising interest rates or disappointing earnings from growth companies could shift performance in favor of value over growth beyond historical averages.
Mixed performance across event-driven factors
It was a very rocky quarter for the merger arbitrage factor. Spreads 1 widened as volatility surged at the beginning of February. No sooner had the factor begun to recover mid-month than a negative idiosyncratic event occurred toward the end of February. Merger arbitrage spreads continued to widen in March as a wave of protectionist and antitrust fears negatively impacted five deals in particular. However, after a difficult January, our expanded suite of event-driven factors delivered gains in March and ended the quarter close to positive territory, making up for some of the losses from merger arbitrage. Share repurchases in particular performed well, even though this factor is known to have a modest correlation to the value factor.
Corporate activity levels remained below their long-term average, limiting the opportunity to gain exposure to event-driven factors without sacrificing diversification. We had expected to observe an increase in activity on the back of corporate tax changes in the U.S. (particularly around repatriation of overseas cash), and, indeed, we are beginning to see that theme play out with respect to share repurchases. Although merger arbitrage activity has been fairly quiet, spreads are now 30% above their recent averages (up from 9% to 12% on an annualized basis); in addition, more than 90% of deals are friendly, supporting the prospects for performance going forward.
Momentum factors suffer from sharp reversals
A transition away from accommodative policy by central banks has led to losses across macro factors. Time-series momentum especially suffered, due to long positioning across equity markets heading into the spike in volatility in February and a shift from long to short positioning across fixed income markets just as the rise in rates reversed. Carry factors were slightly positive, with gains in FX markets offset by losses in fixed income and commodity markets.
The spread between high yielding and low yielding currencies remains below its long-term average (particularly for G10 currencies), as does the difference in term premium across government bonds. Although this suggests a diminished opportunity to capture carry in those markets, rate normalization could improve the opportunity set. Additionally, the difference in roll yield between high carry and low carry commodities increased. Regarding momentum factors, dispersion in price moves across currencies and commodities worsened. However, the number of significantly trending markets stayed at healthy lev-els and we saw a shift in positioning, from long to short across fixed income markets through February and from long to short across equity markets by the end of March.
When all is said and done, a volatile quarter largely improved the opportunity set for factors, with potential catalysts in place across the equity, event-driven and macro spaces. As always, we believe in diversifying across a broad range of compensated factors while minimizing exposure to uncompensated risks.
FACTOR OPPORTUNITY SET
The table below summarizes our outlook for each of the factors accessed by the Quantitative Beta Strategies platform. It does not constitute a recommendation but rather indicates our estimate of the attractiveness of factors in the current market environment.
Learn more about alternative beta and our ETF capabilities here.
1The difference between the target company’s stock price and the announced acquisition price.
– Equity momentum: long/short global developed stocks, based on price change and earnings revisions; sector and region neutral
– Equity quality: long/short global developed stocks based on financial risk, profitability and earnings quality; sector and region neutral
– Equity size: long/short global developed stocks based on market capitalization; sector and region neutral
– Equity value: long /short global developed stocks based on book-to-price, earnings yield, dividend yield, cash flow yield; sector and region neutral
– Merger arb: long target company and short acquirer (when offer involves stock component) in announced merger deals across global developed markets
– Event-driven (other): conglomerate discount arbitrage, share repurchases, equity index arbitrage, post-reorganization equities and shareholder activism
– Macro carry: FX G10 carry, FX emerging market carry, fixed income term premium, fixed income real yield, commodity carry
– Macro momentum: FX cross-sectional momentum, commodity cross-sectional momentum and time series momentum across equity, fixed income and commodity markets
The views contained herein are not to be taken as an advice or a recommendation to buy or sell any investment in any jurisdiction, nor is it a commitment from J.P. Morgan Asset Management or any of its subsidiaries to participate in any of the transactions mentioned herein. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own professional advisers, if any investment mentioned herein is believed to be suitable to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yield may not be a reliable guide to future performance.
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