It has been mostly a difficult year for active fund managers, a JPMorgan equity strategy report notes, as even quantitative funds in the equity space are finding challenging market environments. Underneath the market structure is a stock sector rotation cycle in flux, moving from the overvalued and popular names to the undervalued. What has resulted is a largely rotation driven activity in a low volatility environment that might favor core value investors.
Many funds having difficulty outperforming relative to last year
One can make the argument that the active vs passive shift has really been more of a three or four-year trend, roughly coinciding with the advent and popularization of nonconventional monetary policy. Correlation is not by itself causation, but there are fundamental market structure reasons why active managers, particularly the long / short variety, have been hurt during periods of overwhelming quantitative market influences. Documenting those influences, particularly the non-economic market influences, is challenging. But those who watch technicals underneath the market and track economic correlations have noted more than oddities.
The JPMorgan report, for its part, notes that of fundamental equity funds, only one in three are outperforming their previous year benchmark year to date. For quant equity funds, it is even worse, with nearly one in four outperforming.
What has occurred, according to JPMorgan analysts, is a rotation away from momentum. The concept of sector rotation is, by itself, an anathema to momentum initially, as trend regime change can be causation for strategy challenges.
During the first half of 2016, momentum stocks that were relative outperformers in 2015, sold off sharply. This was particularly the case with growth names, those whose price earnings multiples are typically inflated due to their perceived future potential.
As this occurred, value strategy performance “remained muted,” which resulted in “a relatively challenging environment for fundamental funds,” JPMorgan equity strategists along with quantitative analysts Arun Jain and Marko Kolanovic wrote in an August 24 report. “Quant funds, by contrast, fared better in the 1H as their performance is more closely tied to Low Vol stocks, which have benefited from declining bond yields.”u
Sector rotation has many funds underperforming year over year
For quant and momentum-based funds, the apex of performance often occurs just before a rotation in market environment.
According to JPMorgan’s research, in this rotation environment fundamental and quant equity funds are in large numbers missing performance from the previous year. Of all funds, fully 68% are underperforming their performance last year, with 41% off by 250 basis points or more. For quant equity funds, 74% are underperforming relative to the previous year.
To provide context, in 2015 41% of quant funds were underperforming the previous year while 59% were over performing.
Separate analysis notes significant differences in market environments between 2015 and 2016, which has seen odd correlation breakdowns occur. With the stock market up significantly year to date – the Russell 1000 Value index is up 10%, while the Russell 1000 Growth index is up just 6% — quant funds in general have underperformed. The Societe Generale CTA index, for instance, is up 3.39%. But this under performance relative to the stock market is viewed as positive in some quarters. The fact CTA strategies are positive during positive stock market environments is a relative oddity, as such market environments tend to be statistically more challenging for CTA strategies than periods of higher volatility with sustained market environment persistence. What has occurred in 2016 is that, largely in stocks, downside momentum has failed to persist. In fact, many traditionally strong economic correlations have broken down with stocks moving in separate directions from related assets to various degrees.
In part this explains the long / short price momentum factor underperformance of -17.5% year to date, by far the worst of any of the five long / short execution trigger categories in the JPMorgan study.
Dividend yield long / short strategy top performer
From a sector standpoint, overweight / underweight exposure has been a mixed bag dependent on fund account structure.
JPMorgan notes that hedge fund managers have been favoring discretionary stocks such as retailers over banks and capital goods. Mutual funds have been favoring health care exposure, while underweight staples and technology. Pension funds are overweight financials, but this is almost entirely due to real estate exposure, and non-institutional “insiders/individuals” are overweight consumer staples and telecom.
“Stock-level ownership data indicates significant disparity in relative sector positioning of investor types,” the report observed. “Broadly, Hedge Funds report larger sector overweights than Mutual Funds and Pension Funds, whose holdings more closely resemble the market at large, but we note that Hedge Fund positions include only their long exposure.”
The best performing equity style factor strategies inside the long / short strategy year to date is the value play of dividend yield, far outpacing the seasonality and reversion strategies, which are in second and third place respectively year to date. Among the biggest losers include price momentum, Q-Score and earnings momentum.