The S&P 500 logged a record high Tuesday, capping one of the sharpest turnarounds in market history even as volatility spelunked its way to a six-month low.
Ironically, though, rising markets have been traders’ worst enemy in 2019 as rich valuations amplify investor wariness, stellar market returns make benchmarks difficult to beat, slumping cross-asset volatility complicates hedging, and high correlations frustrate bargain hunters.
Today we’ll survey some popular trading strategies and how they’ve fared in the punishing environment of historic prosperity.
The Fed and ECB moratorium on rate hikes has created a high floor for stocks even as slowing economic growth and idiosyncratic risks like Brexit and trade tensions have imposed a low ceiling.
With valuations elevated, many investors have crowded into quality stocks as defense against a downturn. Bonds’ recent run-up in tandem with stocks has dimmed their appeal as a hedge against equities, stoking the trend. Consequently, observed a Sanford C. Bernstein research note, “‘classic defensive factors are too well bid to be defensive.’”
What’s more, the rotation into quality stocks over bonds represents added risk that touchy investors could seek to unload rapidly at the first sign of trouble, exacerbating a downturn.
Value stocks are meanwhile cheaper relative to growth stocks than at any time since 2000. Still, investors have been loathe to commit to them because “looser monetary policies don’t favor the style.”
Those dynamics — and high correlations in particular — have posed a dilemma for trend-following quants as factors move together, blurring the path to profit. A Bloomberg-compiled portfolio of momentum funds, for example, is off 3% YTD.
Behind those struggles lies an unpredictable market environment responding to Trump tweets and Fed course corrections — about-faces for which trend-following funds are arguably ill-equipped. In a market calibrated in microseconds, such an Achilles heel looks ever more troublesome.
That inconvenient truth has spurred an investor exodus from quant funds, whose AUM dropped 15% from 2017 to 2018, and led to fund closures.
It has also prompted an existential crisis for trend-following quants. “‘It’s a strategy which in its pure terms is really probably obsolete,’” said applied mathematics PhD and former Renaissance quant Robert Frey. A February paper from Research Affiliates argued that “not a single popular factor has provided statistically significant excess returns since 2003.”
Those data points suggest quant funds are not obsolete but rather incomplete insofar as they lack a mechanism for modeling market reversals and how to navigate them. They also raise questions about whether factor investing had become too crowded.
In addition, they’ve encouraged quants to set their sights on other pockets of the investing world that operate on longer time horizons — namely, private equity.
Their options diminished, hedge funds have adopted trading strategies both new and old. The short-vol trade has revived, while more cautious fund managers have shifted to market-neutral strategies like “buying low-volatility names and shorting high-vol stocks, or betting on defensives and selling cyclicals.”
That approach makes sense against an uncertain backdrop in which the 10 most underweighted US stocks are outperforming the 10 most popular stocks by 7%.
Another strategy that could help hedge funds turn a profit in bargain-barren markets while embracing investors’ growing concern over ESG investments is shorting unethical companies.
Increasingly, though, nonplussed traders are wondering whether now is the time to embrace the most reliable risk-hedging strategy of all: getting out.