Momentum Quants Will Unleash the ‘Most Turbulent Rebalance Ever’

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One of the decade’s most successful quant strategies is poised for a dramatic March makeover that threatens fresh volatility for a stock market already reeling from the turmoil in technology shares.

Almost a year after the S&P 500 hit the Covid-spurred low, momentum investors are set to pare exposures to lockdown favorites -- mega-caps and stay-at-home companies -- to join the boom in cyclical equities.

Think less Zoom Video Communications Inc., more Exxon Mobil Corp.

While the rules-based allocation style comes in all shapes and sizes, these traders typically go long the winners over the past 12 months or so while shorting the losers.

Wall Street projections suggest they’re poised to add shares tied to the economic expansion like value, while cashing out of defensive names that have fallen out of favor on policy stimulus and vaccine bets.

All that means a potentially turbulent rebalancing is coming this month across corners of the $2 trillion world of factor investing.

Momentum Quants Will Unleash the ‘Most Turbulent Rebalance Ever’

“The violent downdraft (and subsequent rally) of last March is poised to create the most turbulent rebalance ever for momentum-based strategies,” 3Fourteen Research founder Warren Pies wrote in a note. “The underlying portfolio shift will be dramatic and has the potential to power certain sectors over the coming months.”

A portfolio that buys the 100 top gainers in the S&P 500 would see the largest turnover in at least three decades if it rebalanced in March, according to the research firm. It estimates sectors like consumer discretionary, energy and financials will draw the most inflows, while tech and health care will post outflows.

That would take the cyclical exposure of a momentum trade designed this way to more than 60%, compared with a peak of roughly 40% in 2020.

Momentum Quants Will Unleash the ‘Most Turbulent Rebalance Ever’

Rising bond yields and valuation concerns are sending the Nasdaq 100 Index toward correction territory this week with a 1.7% drop on Thursday -- about 10% below a Feb. 12 record.

While the S&P 500 is struggling to hold onto this year’s gains thanks to the tech rout, under the surface a rotation can be seen. Among the top sectors this week are energy, financials and industrials -- mostly value companies that got battered a year ago in the Covid selloff.

In fact, since vaccine progress buoyed re-opening hopes in early November, value has jumped 25% while momentum plunged 28% in its sharpest top-to-bottom drawdown since the global financial crisis, long-short indexes from Dow Jones show.

That’s a tell-tale sign the trend-chasing factor is currently tilted toward recent losers like tech and health care -- and will soon scoop up shares with depressed valuations.

“The turnover in the signal is high,” said Edward Gladwyn, a portfolio manager at Unigestion SA, which rebalances the factor every quarter. “Indeed it’s higher than the turnover to integrate the post-Covid fallout last July.”

After Shocks

These quant moves can ripple through broader benchmarks. Momentum is popular within the roughly $2 trillion systematic community which groups stocks together by their characteristics, an approach known as factor investing. Exchange-traded funds tied to momentum command $20 billion in the U.S. alone.

The rebalancing will all depend on how the factor is defined. Most typically, quants look at the past year’s price move minus the most recent month’s. More complex styles tend to go long the winners while shorting the losers.

Some portfolios rebalance monthly. Others, including major momentum ETFs, do so every quarter or half year -- suggesting more cash will join the cyclical rotation at the end of this March.

All this could be absorbed by the market comfortably on a typical day. But if enough quants sell the same stock at the same time, there’s always the risk of an increase in trading costs and price volatility.

These “coordinated flows” could be a “source of pain,” Unigestion’s Gladwyn said.

Momentum Quants Will Unleash the ‘Most Turbulent Rebalance Ever’

To be sure, tech’s gains overall in 2020 mean it will remain strongly represented in momentum portfolios going forward. But it’s likely that this breed of investor will pare its exposure to make way for the likes of materials and financials that have staged a strong comeback of late.

A less Faang-obsessed market could be good news for some factor funds. Many have blamed Big Tech’s dominance for the so-called quant crisis of recent years, after a rally powered by the Amazons and Microsofts of this world made it hard to make money without massive bets on these mega-caps.

Now, value equities -- which have famously struggled in recent years -- are finally seeing a ray of light, a boon for those systematic funds with broad exposures.

“Assuming the rotation continues this month and we drop March 2020 observations, we should see value or pro-cyclical increasingly represented in the high-momentum cohort,” said Jon Quigley, chief investment officer of disciplined equity at Great Lakes Advisors.

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