Investment strategies that allocate to alternative sources of beta such as value, momentum and quality have outperformed their equity benchmarks this year, answering many questions about an investment theory that has largely relied on academic research and back tests.
The strength of performance, however, with all standard risk factor styles outpacing their broad benchmarks, is raising questions around strategies that have been lauded for their low correlation characteristics.
In Europe, where the EuroStoxx 50 languishes 8% lower in the year to-date, risk factor outperformance comes as little surprise. Low volatility proved the top performer, with the BNP Paribas Low Volatility Risk Premium Europe Index up more than 3%.
US risk factor outperformance has been more surprising, coming alongside 6% gains on the S&P 500 in the year to-date after the US benchmark surged 20% from February lows to reach an all-time high.
All six alternative beta sources – momentum, value, low volatility, mid-cap, income and quality – outperformed their benchmarks in the year to-date, across both regions, according to analysis from BNP Paribas. That is extremely rare, particularly given that some factors should trade with negative correlation.
“The fact low vol is outperforming while the market is up and is highly correlated with momentum factors, is quite surprising,” said Edmund Shing, head of equity and derivative strategy at BNP Paribas. “We’re also seeing correlation between value and momentum, which is very unusual.”
The S&P low volatility index, dominated by utility, staples and healthcare stocks, typically outperforms when the market falls. This year it has defied expectations, returning more than 11%. Momentum has delivered the smallest excess, raising eyebrows for a strategy that tends to perform in bullish markets.
Short-term anomaly
Academic studies are based on long time-scales and correlation between price-driven styles such as momentum and low volatility and fundamental styles such as value and quality changes dramatically over time, according to Nick Baltas, quantitative analyst at UBS.
“Over the year, we’ve seen a few different themes emerge and we’ve witnessed shifts in correlation between price-driven and fundamental styles. While 2015 was dominated by momentum and quality styles, in 2016 we’ve seen a few more significant reversals,” said Baltas.
An array of market anomalies and volatility events may also have made strategies less predictable, BNPP’s Shing said.
“We’re in a very strange situation and we’re seeing some very strange performance as a result,” said Shing. “A third of the sovereign bond market is trading in negative yields, which is unexplored territory, and we’re also moving towards divergent monetary policy, with the Fed in tightening mode while the Bank of Japan and Bank of England may loosen further. This is a very different economic world and we are already seeing many anomalies as a result.”
Crowding effect
Analysts are investigating the impact of any crowding effect on the apparent uptick in correlation as investors embrace passive strategies. Assets in smart beta ETFs stand at more than US$280bn, according to BlackRock’s iShares, and are on course to reach US$1trn by 2020.
“The advent of smart beta investing has caused a lot of capital driving these themes and a lot of people asking whether increased correlation could be the new norm,” said Baltas. “Crowdedness on its own merit is not a bad thing as you need crowds on your side to make money. The party only becomes dangerous when someone wants to exit and the door is very small.”
Crowding is less of an issue for fundamental styles such as value, where low-cost stocks are replaced by a new universe once valuations increase. For price-driven styles such as momentum, which rely on the performance of past winners, crowding is essential for the trade to work but can trigger a rush for the exits once return targets start to be hit.
“Crowding doesn’t make risk premia go away, it just makes it harder to harvest the spread as you need faster rebalancing and more costly processes,” said Baltas.
As unpredictable it may have been, the strength of risk factor strategies is likely to further fuel growth across alternative strategies.
“Given the strange set of events we’re facing and uncertainty over how assets will perform, one solution is to consider multi-factor ETFs. The odds are that at least one factor will outperform the market,” said Shing.