The two data points have drawn headlines. First, in the world of ETFs, we have seen outflows over the late summer months as investors caught the mood of uncertainty emanating from the US and Europe.
Then there has been the apparent switch in the world of factor investing from momentum – which has been the play of the decade – to value. A blog from Leon Roisenberg and George Bonne, who lead the equity research team at MSCI, point out that the US momentum factor suffered a 4.7% drawdown in the month to mid-September while both the yield and value factors gained over the same period.
Is there a link between these two strands of news? Nicolas Rabener, managing director of FactorResearch, cautions against making a causal link. “Although intuitive, it is challenging to show a statistical relationship between flows and factor performance, likely due to poor and delayed flow data.”
“We therefore measure crowding with technicals derived directly from the market like volatility, dispersion, valuation, performance, and residual correlation,” he adds. “All factors can and have historically been crowded at some point, which results in drawdowns. Despite the recent increase, value is more uncrowded than crowded currently.”
Rabener points out momentum currently has an overweight to the technology sector and this is where many ETFs have been launched. However, the recent shift in sentiment typified by the pulling of the WeWork IPO, has played into the factor rotation.
“If this continues, then investors will likely reallocate from tech to other sectors and indirectly away from momentum stocks. However, as mentioned, the momentum portfolio will then simply adapt and include the currently best-performing stocks.”
Of course, we are into the realms of definitions and quant theory here so we need to be careful about the terminology.
As Peter Sleep, senior investment manager at 7IM, suggests, the analysis from MSCI is particularly opaque if you are at all vague on what they are talking about. But helpfully, he breaks it down into layman’s language.
“In the last few weeks there has been a bit of a quant crash in momentum, with certain securities, that had demonstrated good momentum – think the communications and tech sectors in the US – doing poorly and certain value-orientated sectors of the equity market doing well like utilities and financials,” he says. “This has occurred at a time when the overall direction of the equity market has been relatively benign.”
But he is sceptical as to whether this movement can be correlated with ETF flows.
“This phenomenon is separate to the performance chasing behaviour we often see in ETF flows,” he states. “Here simply if a market goes up you often see ETF flows follow.
“Fixed-income performance through to the end of August 2019 has been very good and this was reflected in very positive ETF fund flows. The gold price has been very good and gold ETF flows have been very good.”
The missing link
Which is not to say that the two elements of market behaviour are not intertwined in some manner.
Damian Handzy, chief commercial officer at Style Analytics, points out that the recent influx of money into ETFs (at least up until August) and factor-based ETFs, in particular, means that the factors “take on a life of their own” and are traded almost as if they were the market’s “atomic units” rather than stocks.
He explains one of the challenges with stocks is that their volatility has always been higher than the volatility of the dividends their prices purportedly discount.
Previously, this has led to investment opportunities being formed on fundamentals i.e. stocks that temporarily dropped in price due to high market volatility but which still displayed strong fundamentals would bounce back once the markets settled down.
“The influx of money directly in factor-based ETFs can dominate the market dynamics for long periods of time, as they have,” he adds. “It is almost as if micro-fundamentals do not matter in this scenario. That is true – to a point.”
As befits the name, “momentum begets momentum” notwithstanding the obvious corollary that the P/E ratio for these stocks keep on climbing.
“For the past few years, the fundamentals have not mattered very much: if they did, value funds and value ETFs would have made much more than they did,” says Handzy. “If one believes in regression to the mean then one has to also believe that the markets will once again clear their heads and fundamentals would take over: the result would be a total reversal of the past few years’ value/momentum trajectories.”
It is at this juncture that the nature of ETF ownership intervenes. In order to perfect a strategy of timing any switch from momentum to value, you need to be something of a sophisticated investor with the ability to profit from temporary mismatches.
Handzy’s point is this is not the profile of the average retail ETF investor. “It is much easier to sell an ETF on the foundation of the momentum argument: ‘these stocks are hot, so put your money in now’.”
“It is truly unclear which of these competing views will win out in the long term, but it is quite clear that a large tail-risk event such as a crash in some other asset class or trade war or a hard Brexit would likely set the market back to rational behaviour.”
This, perhaps, is where the foundation argument over ETF bubbles is formed. That return to “rational behaviour”, despite having its own market logic, would be harmful to many investors that have bought into the tech-led momentum story.
“Will some of the ETF money exit altogether if momentum as a factor is going backwards?” asks Sleep.
“Momentum as a quant strategy is going backwards because the stocks that have done well in the past are not doing so well and the stocks that have done poorly in the past have done well in the last few weeks.”
That does not necessarily mean the market will go down; it might just men there is a rotation of over-bought stocks into “more neglected areas of the market.”
“If the equity market stays healthy, we will see ETF inflows. Mind you the last time we had a similar quant reversal like this was in August 2007.”
Warning enough perhaps?
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