Their fundamental counterparts are having a banner year. Stock correlations are at all time lows and clearer market trends are breathing life back into the momentum trade, a strategy among equity quants that bets the winners will keep winning. As those shares chart increasingly independent paths from the losers, equity fund managers are recording their strongest performance in five years, data compiled by JPMorgan Chase show.
Yet for market-neutral quants who take advantage of patterns and dislocations, this year has been anything but a standout. Only 30 percent of those managers are beating their benchmark, compared to 51 percent of fundamental equity managers, according to the bank.
The culprit may be fundamental managers’ biggest ally: high dispersion among individual stocks and between sectors. Not only are quant funds more diversified and less likely to benefit from concentrated gains, but low correlations have contributed to a dearth of volatility, which is a death sentence for many quantitative funds.
Improvement for fundamental managers “is partially explained by the record high stock dispersion, higher exposure to growth/momentum sectors,” JPMorgan’s equity strategy and quantitative team, headed by Dubravko Lakos-Bujas, wrote in a recent note to clients. “These factors may also explain why discretionary managers are delivering stronger performance than their more diversified quant peers, whose portfolios are generally sector-neutral with static risk budget across styles/factors.”
For quantitative funds, it’s less helpful when a single stock bounces around. Many quants tie their fortune to groups of companies with common characteristics, like low cost or high profitability. But even if those wagers are correct, the potential returns are limited without volatility, which has all but disappeared from today’s market.
Near record-low correlation has helped mask volatility between individual stocks, creating a smoother ride for the broader market. Among global equity indexes, average correlation in October was the lowest in at least a decade, while volatility for seven of 18 major global indexes sank to 10-year lows, according to data compiled by S&P Global.
Making matters worse, quants have become even less dependent on single-stock returns while market leadership has grown increasingly thin. Quantitative funds that own more than 200 companies have the highest share of assets since at least 2005, data from Sanford C. Bernstein & Co. show. With more diversification, the quants benefit less from this year’s few standout shares.
“It appears that for a portfolio with 3,000 names, it isn’t able to harvest this initial rise in dispersion,” said Mark Connors, Credit Suisse Group AG’s global head of risk advisory.
Still, it’s a strange turn of events for the computer-driven strategies considering one of their main factors has done so well as of late: momentum.
Market-neutral momentum, which bets on the biggest gainers over the past 12 months while shorting the worst, advanced 4.9 percent in October, the biggest monthly gain since June 2016. Meanwhile, equity market-neutral funds fell 0.4 percent, according to a basket compiled by Hedge Fund Research. Monthly correlation between the quants and market-neutral momentum is its lowest since 2013, according to data compiled by Bloomberg.
What’s more, fundamental managers have been taking advantage of momentum’s strength. They’re highly concentrated in technology, which as this year’s best performing sector, contains a large amount of momentum stocks. But while equity managers can make outsized bets on technology stocks, market neutral quants typically hedge out sector risks, leaving them unable to take advantage of one of the few winning wagers of 2017.
To be sure, quants who’ve infused their portfolios with momentum bets have performed exceptionally well this year, according to Connors. But for many portfolio managers, technology and momentum selloffs like those from earlier this year have created a factor too volatile to stomach, he said.
“The only differentiated factor this year is momentum, and everything else is clustered,” Connors said. “Quant funds respect both the upside and the downside of momentum, choosing to be thoughtful about letting the portfolio realize a more purposeful dispersion as opposed to targeting this more mercurial momentum animal that rears during rotations.”
©2017 Bloomberg L.P.