Happy New Year!
The end of one year and the start of another is always a time of introspection and reflection. In this case, we would like to apply that introspection to the factors that we help our clients track. We'll lead with what most investors are interested in - headline performance - and then revisit specific instances that could benefit from extra reflection.
*Indicates that the polarity of the factor is low-high, rather than high-low
The outperforming factor in 2016 was Dividend Yield. Dividends were one of the few places where investors could soundly beat the market. Companies with a long history of stable earnings distributions benefited from an environment of political uncertainty. Otherwise, the S&P 500 significantly outperformed every other factor except for Book/Price and % 4Wk Reversal, which had similar performance.
The worst place for quants to be this year was in simple momentum, followed by low beta stocks. Momentum not working is a symptom of investors not being comfortable enough to ride any specific trend. For most of this cycle investors have been very comfortable being long technology, but this year was a mixed bag for tech.
Low Beta’s underperformance may go hand in hand with Low Volatility’s underperformance. Both have negative correlation to the market’s performance, and the last thing that funds want to be is underweight beta and volatility in a market that is drifting upwards. Many funds are already at a disadvantage as they must hold some amount of cash for distributions while still tracking an index, and being exposed to low beta and low volatility stocks only pays out when the cycle turns. It’s painful on the way up.
There were no pure quant crashes this year, but there was still some interesting volatility. There were four volatility spikes in the US stocks market this year. Each spike hit factors differently.
The first and most extreme bout of volatility came at the start of the year as turbulence in Chinese markets threatened to spill over into the rest of the world. China’s blue chip CSI 300 market at one point fell over 7% in one day. When we look at factor performance around this initial panic, we can see that Low Beta and Low Volatility factors outperformed, while dividend yields underperformed with the market.
After China’s central bank initiated a controlled devaluation and oil prices stabilized, the market slowly recovered. The next shock wasn’t until June 23, 2016.
In a theme that repeated itself this year, election results stunned pollsters and those who believed that everyone had bought into globalization as much as the educated classes of developed countries.
The immediate results of this shock were short lived. Movements in the factors on the day of the vote were reversed later in the week. Identifying these types of reversible factor movements in market panics is a big reason to track factor performance. Knowing that a stock is moving because it has strong factor exposures would be very reassuring to a portfolio manager wondering if their momentum stock had some extra exposure to Brexit that they did not properly anticipate.
The Last Three Months
September started out with worries that the central banks of the world were no longer going to be providing the world economy, or perhaps more importantly, world markets, with as much extra liquidity. These worries caused oil to drop by 4% and the S&P 500 to drop by 2.5% on September 9th. However, Federal Reserve officials assured market participants that the removal of accommodative policy would be gradual and the markets relaxed.
The next worry came as it looked like the status quo candidate, Hillary Clinton, was slipping in the polls. Markets started to panic on the night of Trump’s election, but his speech seemingly reassured investors that any changes he had in mind would not negatively impact the stock market. Soon, markets started to price in the end of election uncertainty and the idea that Trump would benefit financial and infrastructure related companies.
The only factor to really underperform into year-end were the low beta stocks, which are generally expected to underperform in a rising market.
2016 had a few market dislocations, but there were no outright factor panics. While hedge funds saw net outflows in 2016, the amount of money managed by quant funds is still growing. Low fee products, or at least lower fee than the traditional 2 & 20 of hedge funds, are attracting additional capital while pushing more people into the same crowded trades. The top five low volatility ETFs alone have over $30 billion dollars under management. It would not be a mistake to equate excessive exposure to popular factors with excessive exposure to crowded trades.
As a reminder, Omega Point clients have access to a regularly updated Factor Return Summary.
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We hope that 2016 treated you well and that 2017 will be even better.
The Omega Point Team