Tuesday, 22 December 2009

Quality Factors in Equity Hedge Fund Returns This Year

In 2008 one of the disappointments was the returns of market-neutral quantitatively-driven equity strategies. The difficulties were focused as much as anything else in the seemingly illogical behaviour of quality factors last year. I recently inquired to a senior researcher in equity quant about factor returns this year, and again quality factors have driven returns in unexpected ways. The behaviour of quality factors helps to explain equity hedge fund returns across different styles this year, and so I have included the following abstract from the research of this quant published at the beginning of this month:


Discerning the direction of the Quality trade remains the key issue for investors. Discussions of investors seeking to take money off the table heading into year-end and positioning themselves in a more defensive posture are not borne out by the behaviour of our Quality index.

Market Commentary

It has been a tough year for Quality. And it has been a tough year for stock picking. And these two facts are not unrelated. Indeed, over the past 9 to 10 months, the key to successful stock picking has been to understand the direction of the Quality trade.

The big news in the quantitative factor space, and really the market as whole, this month has been the underperformance of High Quality stocks relative to Low Quality Stocks. For the month, we saw High Quality stocks underperform Low Quality stocks by approximately 2.9%. For our quality index, this is a big move since, in general, our quality index runs at approximately 1/3rd the volatility of the Russell 1000. In other words, if our quality index were scaled to have the same volatility as the Russell 1000 index, we would have seen an approximately 8.5% down move in our Quality index this month. Clearly something is happening.

Backing up for a second: as most people are aware, the rally in the market that started around mid-to-late-July coincided with a very strong move upwards by low quality stocks. Specifically, we saw low quality names outperform high quality names by approximately 5.2%. Whereas the low quality junk rally in March was primarily focused around companies with distressed balance sheet and low stock prices, the July rally was much more broadly focused. Here we saw low quality companies of all stripes outperform. Companies with poor historical profitability outperformed. Companies with low quality of earnings (i.e. non-repeatable earnings) outperformed companies with high quality of earnings. And companies with low quality balance sheets outperformed those with high quality balance sheets. In short, the late summer rally was coincident with low quality stocks of all stripes outperforming.

Since that time, we have seen a reversal in quality and then this month a subsequent continuation of the low quality trend.

Now this stopped around September 16th as we headed into earnings season. From there to the end of October we saw High Quality outperform Low Quality stocks by approximately 4.5% as investors positioned their portfolio defensively and braced for what by all respects they feared would be a tough earnings season. Note, again these are large moves, if scaled to equivalent Russell 1000 vol, this would be a 13.5% move in a month and half.

This turned around again on October 28th, with another strong low quality rally emerging coincident with strong earnings announcements by banks, basic materials and commodity producers, consumer goods companies and REITs – in short, bellwether companies for any weakness in the recovery. As these decidedly good earnings numbers provided assurance of the recovery's continuation, investors took off defensive positions and piled back into the early stage cyclical recovery trade names. This trend has continued virtually unabated ever since, with the Quality index experiencing positive returns on only 6 of the 20 trading days last month (November). Discussions of investors seeking to take money off the table heading into year-end and positioning themselves in a more defensive posture are not borne out by the behaviour of our Quality index.

Perhaps the most surprising element to us was that the quality index has continued its downward march late last week even on the news coming out of Dubai, which instilled some measure of fear in the market. We would have expected a flight to quality on Friday as the story broke and world equity markets lurched down. But it didn't happen. Our Quality index continued to inch downward on Friday (-4 bps) and then again on Monday (-23 bps), as even geopolitical fears did not send investors fleeing to safety.

As we head into year-end, the pressing question is: do we anticipate a rally in Quality? Absent a high-impact geopolitical event, we see two scenarios under which the Quality rally can end. Namely, investors can become concerned about slowing growth and thereby move into a more defensive posture in their portfolios.

We believe the most likely cause of a pull-back in Quality is the likelihood that investors take money off the table from the strategy as valuation of low Quality stocks is no longer compelling. By most metrics that we use to judge, low quality stocks appear to be fairly to slightly richly priced.

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