Beloved Quant Trade of 2019 Is Under Threat Now Risk Is Back

(Bloomberg) -- The market optimism that has fueled a switch into cheaper and more volatile stocks may bring one of this year’s soaring quant trades back down to earth.

Until recently, European low-volatility shares were a market favorite, with exchange-traded funds linked to the strategy showing record inflows last quarter. But as a budding U.S.-China trade deal boosts optimism on growth, money is flowing into shares that tend to see bigger swings such as value and cyclical names -- at the expense of defensive bets trading at rich valuations.

“The low-volatility factor is at risk,” said Inigo Fraser Jenkins, head of global quantitative strategy at Sanford C. Bernstein. “There has been a big shift over the last month, we think more portfolio managers will position into the value strategy instead."

Until this fall, a bet on stocks with tame price swings had a clear appeal in a market fraught with fears about liquidity, a trade war, easing profit growth and economic angst. Investors who were burned in the sudden sell-off at the end of 2018 were particularly keen to protect themselves.

The strategy was particularly relevant in Europe, where traders were also grappling with political uncertainty around Brexit and concerns about a recession in Germany. However, the crowded trade is losing its shine as traders seek out riskier assets and exit more expensive safety bets.

Bond Menace

After the MSCI Europe Minimum Volatility Index returned 16% since the start of the year through the end of August-- six times that of the MSCI Europe Value Index -- the valuation of European low-volatility stocks hit a record high compared to value shares. The premium has been shrinking ever since, accelerating over the past few weeks, as rising bond yields and positive news flow spurred a shift away from defensive equities and bond proxies.

The factor team at Legal & General Investment Management was among those who noticed the “extreme” pricing difference and has been selling low-volatility stocks and buying value shares over the past two months, said fund manager Andrzej Pioch.

“Our quantitative tool likens the current macro environment to early months of 2000, partially because of similar levels of value dispersion, which subsequently saw value outperforming,” said Pioch. “We have been gradually moving into value and away from low volatility, which scores worse on valuations -- in particular, earnings yield and free cash flow yield -- and sentiment.”

Exchange-traded fund flows offer yet more evidence that investor sentiment is shifting. BlackRock Inc.’s iShares Edge MSCI Europe Minimum Volatility ETF last week resumed outflows that were last seen during the September rotation into value and BNP Paribas Equity Low Vol Europe ETF saw its largest single-day redemption in a year. In contrast, the Amundi MSCI Europe Value Factor ETF posted its biggest weekly inflow of 113 million euros ($125 million) in late October.

At the same time, the strong switch into value and cyclical shares stands on fragile ground that could be broken by any escalation in U.S.-China trade tensions or signs that economic growth is faltering. HSBC Bank Plc strategists led by Max Kettner say risk assets are ripe for a pull-back in coming weeks, saying macro data don’t justify recent outperformance.

“Low vol is well-positioned to do particularly well going forward,” said Nick Alonso, director of the multi-asset group at PanAgora Asset Management. “There’s no shortage of uncertainty coming from Europe but positioning a strategy to be more defensive globally, that’s a pretty strong position to be in going into the next year."

The tactic helped Los Angeles Capital Management, a quant firm which oversees $25 billion in equities, maneuver the complex world of British politics this year as its U.K. stocks strategy reaped 16% through the end of September. And considering the outcome of the December Parliamentary elections isn’t certain and the exit from the European Union may take more time, price swings may return sooner rather than later.

The low-vol strategy’s Achilles heel, however, is its high sensitivity to interest rates and elevated exposure to bond proxies. Utilities, real-estate and telecoms are among the defensive sectors that investors have been exiting the most this month in Europe.

Over at Societe Generale SA, the head of quant strategy Andrew Lapthorne says that this year’s profits from the low-volatility trade “are disappearing fast” as value rebounds.

“Investors who bought bond-proxy equity might be surprised at the downside given they are often wrapped into safer investment vehicles,” said Lapthorne. “Value investors I think are well aware of the risks and to a large extent value stocks are already discounting many of the issues.”

This week brought further positive macro news. A rebound in German factory orders was followed by China saying Thursday it has agreed with the U.S. to roll back tariffs on each other’s goods in phases. Cyclical and value sectors led the advance in European equities, with automakers, miners and banks up at least 0.9% as of 12:34 p.m. in London.

“The expensiveness of the low-vol factor in the U.K. and Europe is easing amid the current global risk-on mood,” said Masanari Takada, a quant strategist at Nomura Holdings Inc. “Further positive factors -- like a U.S.-China trade deal, picking up of global economic momentum -- could relax investors’ cautious stance and likely induce further factor rotation in the equity market."

To contact the reporter on this story: Ksenia Galouchko in London at kgalouchko1@bloomberg.net

To contact the editors responsible for this story: Blaise Robinson at brobinson58@bloomberg.net, Namitha Jagadeesh, Sid Verma

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