Something scary this way comes from Morgan Stanley's Quantiative and Derivative Strategies: "market conditions over the last two weeks are somewhat reminiscent of that during the August 2007 ‘Quant Crisis’. In only a few days, a number of quantitative long-short equity funds experienced unprecedented losses in seemingly ‘normal’ market conditions. We do not suggest here that the magnitude of hypothetical losses match those from 2007, however, there is little question that the rotation has drawn attention of many quant investors." In other words, the massive groupthink trade that we have been warning about for months may be about to claim its first mass casualties.
The just released report by author Charles Crow elaborates what many have been suspecting, yet few dared to voice: "Recent substantial factor movements in Europe have contributed to portfolio volatility and, in some cases, abrupt performance degradation. Portfolios positioned to take advantage of prevailing factor trends may have suffered substantially over the last two weeks." Is the groupthink trade about to end? If so, does that mean the funds will be forced to stop "not fighting the Fed" as this is really the only factor-driven trade that has made sense. If so, we have reached the critical point where being aligned alongside the Fed has no incremental marginal returns, at least for the non-Primary Dealers. This could promptly transform to a watershed event, especially since as Morgan Stanley adds, the market currently has "relatively low liquidity" to absorb the fringe moves.
More details from Morgan Stanley:
Recent substantial factor movements in Europe have contributed to portfolio volatility and, in some cases, abrupt performance degradation. Portfolios positioned to take advantage of prevailing factor trends may have suffered substantially over the last two weeks.
These rapid and significant reversals of factors returns have caught many investors – quant and fundamental managers alike – on the wrong side of a trade. The broad rotation also raises the question whether this represents the beginning of a secular shift back into Value at the expense of Momentum, Quality and Growth. Alternatively, the rotation may signify an idiosyncratic quant portfolio rebalancing in a market of relatively low liquidity.
We first seek to place the recent factor returns in a historical context. Exhibit 1 presents the weekly cumulative factor performance over the first three weeks in January. The fundamental factors span major investment styles, including Value, Growth, Momentum, Financial Leverage, Quality/Profitability and Free Cash Flow. To appreciate the recent rotation, also included is the cumulative performance of each factor over the entirety of the 2010 fourth quarter.
The above performance is sorted according to the week of January 17 – a period that realized substantial and persistent factor returns. It is evident that the rotation began over the week of January 10 (specifically, our data suggests it started on Tuesday, January 12).
The magnitude of weekly factor performance is striking and, in some cases, exceeds absolute factor performance over the entirety of 4Q10. Quant portfolios positioned to exploit recent Style trends – portfolios potentially long Quality (e.g., ROI), Growth (e.g., 1-Yr Est. EPS Growth), and Momentum (e.g., 12-Mth Price Momentum) – have endured violent reversals in many underlying positions.
For example, 12-Mth Price Momentum gained 4.2% over 4Q10, yet declined 5.3% during the week of the January 17. Negative Momentum is an indication of broad mean-reversion in the underlying equity market (e.g., ‘churn’). In fact, the factor realized -10.0% over the last eight trading days through unrelenting negative performance. The factor’s return exceeded 2-standard deviations moves on four of the last eight days. On January 12 – the first day of the ‘rotation’ – the factor realized -2.6% on a single day (a 3.9-standard deviation event).
All of this factor turbulence was realized in a range-bound equity market. Despite the recent increase in realized volatility, absolute levels remain historically low and expected short-term volatility has declined over the last ten sessions – see Exhibit 2. The VStoxx Index, which measures the cost of protecting against a decline in the Euro Stoxx 50 Index, declined 3.1% over the week of January 17.
Thus, market conditions over the last two weeks are somewhat reminiscent of that during the August 2007 ‘Quant Crisis’. In only a few days, a number of quantitative long-short equity funds experienced unprecedented losses in seemingly ‘normal’ market conditions. We do not suggest here that the magnitude of hypothetical losses match those from 2007, however, there is little question that the rotation has drawn attention of many quant investors.
Exhibit 3 emphasizes the magnitude of recent daily factor returns in Europe. The +/-1 standard deviation bands from September 1, 2010 to January 21, 2011 overlay the daily factor performance. A number of factor returns over the last two weeks have well exceeded 2-standard deviation events. Despite the recent uptick in market volatility, factor trends since the start of the rotation on January 12 have been largely one-sided.
One assumption from Morgan Stanley is that we are seeing an unprecedented-scale sector rotation by the quant community as it attempts to diversify from a huge one-sided trade, which is forcing many funds to get blown out of the water on loser positions.
Sector-level excess returns of the two factor quintiles suggest a relatively broad-based rotation. Book/Price, that has gained 5.8% over the last two weeks, has largely seen its ‘cheap’ portfolio outperform across sectors. Similarly, the ‘expensive’ segment across sectors has concurrently underperformed.
Analogously, the best performing names within our 12-Mth Price Momentum have largely underperformed consistently over the last two weeks, while the worst performing names have outperformed.
Although there are exceptions (e.g., -3.1% excess return within the worst performing Info Tech portfolio on January 13, which is a relatively concentrated European sector), the overall performance of the two factors appear to be driven uniformly across sectors. An open question is whether this rotation is short-lived or we will be experiencing a continuation of the reversal in the coming days and months.
A number of quant managers have adapted their approach to investing by taking into consideration risk factors such as crowded trades and abrupt style rotation. While some would have been less exposed to this recent trend, the environment continues to be challenging.
Our less than politically correct interpretation of this finding, as noted above, is that the traditional "don't fight the Fed" trade, validated by whatever combination of factors, is now on its last breath, and all those who are caught in it last, will see massive losses, ergo the scramble to rotate out. Should this indeed be the case, we are due for some material market turbulence as the quants struggle to reposition themselves in a market which is now longer dependent on the day to day whims of Ben Bernanke and the "Sack Frost" POMO dynamic duo. Lastly, if indeed we are in the midst of an August 2007-type of Hurricane, it is about to get a whole lot messier. Add Tom DeMark's expectations for an 11% decline in stocks, and not even the "Fed Frontrunners" may be able to continue the melt up at this point.