A $1.5 Trillion "Quantamental" Market Opportunity

Tyler Durden's picture

While the debate rages if retail investors have eased on their boycott of the stock market, making it increasingly difficult for institutional investors to dump their holdings of risk assets to Joe and Jane Sixpack even as active investors continue to suffer unprecedented redemptions amid a historic shift from active to low-cost, factor-driven passive management, in today's Sunday Start note from Morgan Stanley Andrew Sheets, the cross-asset strategist points out that the next $1.5 trillion market opportunity may be a fusion of retail and institutional preferences, namely a low-cost quant approach to investing, coupled with a legacy, fundamental strategy.

As Sheets writes, "$1.5 trillion of AuM currently managed under quantitative guidelines could continue its double-digit growth over the next five years. Part of this growth is a  ‘pull’ from investors broadening their search for risk premium and uncorrelated returns at lower fees than traditional alternatives. Part of this is a ‘push’, as asset managers see systematic strategies that lend themselves well to automation and scale, offering value over pure ‘beta’ in a traditional active management framework. Relatively small further reallocation by asset owners towards these strategies could still drive significant growth."

And while that may come as soothing words to asset managers scrambling to shift from fundamental to a fusion, or "quantamental" investing approach, Morgan Stanley then sets a cautious tone asking whether "this growth is occurring at the wrong time" pointing out that "there are serious concerns over whether the flow we’ve already seen into these strategies explains a recent deterioration in performance, and is leading to a dangerous ‘crowding’ of too much money chasing the same factors."

This goes to the whole "ETFs are socialist products which are destroying both portfolio selection and capitalism, and making markets illiquid, fragmented and at risk of seizure" argument that has been discussed here over the past few years.

For the record, Morgan Stanley is not too concerned, and instead casts the blame on the "unusual environment of distortive central bank policy, an EM and commodity bear market, and high asset correlation. Those dynamics, we think, offer a better explanation for why performance was poor, and incidentally, are all in the process of rolling back."

What about crowding? According to Morgan Stanley, "this debate is hotly contested, especially as we’ve marked the 10-year anniversary of the ‘quant crash’ in mid-2007. It is difficult to resolve, especially because things don’t need to be popular to have problems, and well-liked strategies can persist for extended periods of time. So we’ll shift the question: Are factors much more expensive than normal (relative to the market), perhaps because of these flows?"

For the answer, read the full note from Andrew Sheets below:

Quant and Fundamental – Better Together

 

 

We expect significant further growth in assets that are managed with some form of quantitative mandate. That has implications for markets, and for investors trying to navigate them. Later today, we’ll be publishing a detailed analysis of these issues, with a focus on what we see as the most notable opportunity – increasing fusion between fundamental and quantitative approaches. Consider this a preview.

 

My colleague Michael Cyprys estimates that ~US$1.5 trillion of AuM currently managed under quantitative guidelines could continue its double-digit growth over the next five years. Part of this growth is a  ‘pull’ from investors broadening their search for risk premium and uncorrelated returns at lower fees than traditional alternatives. Part of this is a ‘push’, as asset managers see systematic strategies that lend themselves well to automation and scale, offering value over pure ‘beta’ in a traditional active management framework. Relatively small further reallocation by asset owners towards these strategies could still drive significant growth.

 

This ~US$1.5 trillion estimate casts a wide net, from funds that explicitly emphasise a factor like ‘value’ to those doing sophisticated, systematic multi-asset trading. Yet despite this range of complexity, the underlying premise of a rule-based approach is generally the same. Our work focuses on a key building block, factors, which can be thought of as the answer to questions such as “what if every month I just bought cheap stocks and sold rich ones, or bought high-carry and sold low-carry FX, and did that over and over and over again?”

 

The answer is interesting. There is a litany of work showing the existence of risk premium for these factor strategies over time. We aim to add to this debate by looking at factors from the micro (stock) to macro (asset class) level, globally. Combining the work of Brian Hayes on equity-level factors with work by my colleague Phanikiran Naraparaju on macro ones, we see an encouraging case for diversification, given the (low) correlation of factors to the market and with each other.

 

But is this growth occurring at the wrong time? There are serious concerns over whether the flow we’ve already seen into these strategies explains a recent deterioration in performance, and is leading to a dangerous ‘crowding’ of too much money chasing the same factors.

 

Let’s start with recent performance. Over the last five years, systematically trying to own things with better value, carry or momentum has done worse than the long-term average. This is true whether you’re looking at the micro world of stocks or the macro world of asset classes. But we’re not sure that investor flows explain this. First, we’d venture that ‘too much money’ chasing strategies would have the opposite effect, causing these strategies to over-earn.

 

Second, this period covers an unusual environment of distortive central bank policy, an EM and commodity bear market, and high asset correlation. Those dynamics, we think, offer a better explanation for why performance was poor, and incidentally, are all in the process of rolling back.

 

Which brings us to crowding. This debate is hotly contested, especially as we’ve marked the 10-year anniversary of the ‘quant crash’ in mid-2007. It is difficult to resolve, especially because things don’t need to be popular to have problems, and well-liked strategies can persist for extended periods of time. So we’ll shift the question: Are factors much more expensive than normal (relative to the market), perhaps because of these flows?

 

Our work suggests the answer is often ‘no’, with valuations on a majority of factors at both the stock and asset class level closer to long-term averages than extremes. This doesn’t mean there isn’t a risk of drawdowns from automated strategies, but we do think it mitigates this risk, as expensive factors would have further to fall.

 

However, these risks bring us to our main point – the opportunity in combining quantitative and fundamental approaches. We think that quantitative approaches can benefit from passing through a level of fundamental scrutiny, and fundamental investment analysis can benefit from being aware of where factor exposure exists.

 

These aren’t, we’d argue, just general platitudes. At the micro level, work by our equity quantitative strategists has shown that stocks favoured by quantitative screens and Morgan Stanley analysts do better than either alone. At the macro level, our new systematic framework for scoring cross-asset factor exposure (CAST) suggests that even simple, unoptimised approaches of screening assets can improve macro calls. For all their promise and sophistication, systematic strategies in financial markets can still struggle with limited data and the difficulty of adapting to regime shifts. Amazon, for example, has scored poorly for years on ‘value’ and ‘carry’. It has still done quite well.

 

At the same time, if factors do tend to produce positive returns over the long run, why wouldn’t fundamental analysts want to know about them? At the very least, we like the idea of knowing which of our calls are aligned (or misaligned) with value, carry and momentum. And as we search for new views, we look for which assets might have all those properties that we’ve inadvertently missed. At present, assets that our strategists like fundamentally, and also screen well on a factor basis, include Chinese equities and RUB, whereas CHF and JPY screen poorly and are disliked by our strategists.

The implications of the above, if taken to their logical extreme, are concerning: what Morgan Stanley is saying is that contrary to centuries of conventional financial wisdom and study, fundamental, value investing is no longer a key driver of future returns, and instead the things that do matter in this "market", include what the consensus algo, or robotic trade du jour is, and what quant factor will define returns over the immediate future period.

In other words, the math PhDs have officially taken over. It also means that for the sake of all those legacy traders and investors who learned finance the "old-fashioned way", they better have practical skills that are applicable far away from what was once Wall Street, and is now just a bunch of algos frontrunning each other and the Fed.

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johngaltfla's picture

Translation: Put your money on the 0/00 line for the largest returns and hope the roulette wheel isn't rigged that day.

any_mouse's picture

Throw stuff at the wall and see what sticks like shit.

Being "Mental" is the operative part of this strategy.

ElTerco's picture

I think you meant to say, "...and hope the roulette wheel *is* rigged that day."

silverer's picture

It's amazing to me that the economy has gone from one that produces tangible goods with added value to one producing methods of developing wealth without any productivity, labor, or anything being produced. How inconvenient that we have to grow food. As soon as humans can live off eating zeroes and ones, and heat their living space with the magic of carbon-free profits, the better off everyone will be. Right? Hmm...

beyondtheprogramming's picture

This set up could succeed only through our active participation. We could quash all of these quasi-imaginary asset inventions - if we would simply stop depending on them en masse. Maybe we could start stoning each other?

Fish Gone Bad's picture

We make friends and beaucoup weapons.

Muppet's picture

Nonsense mumbo jumbo...

"asset managers see systematic strategies that lend themselves well to automation and scale, offering value over pure ‘beta’ in a traditional active management framework"

"We expect significant further growth in assets that are managed with some form of quantitative mandate. That has implications for markets, and for investors trying to navigate them."

 

Dragon HAwk's picture

You can paint the plane any color you like, but when the engine quits, you don't get off the ground

Rainman's picture

A quant, a mechanical engineer, and a chemical engineer are shipwrecked on a deserted island. They are starving, and are tired of eating coconuts. They come upon a can of food on the beach....

The mechanical engineer says, 'let's wedge the can between these 2 palm trees and rig a branch to chop the top of the can off'. The other two quickly point out that this will destroy the can and likely send the contents all over the place, wasting them...

The chemical engineer says, 'let's take the sea water and reverse the polarity of the water extracting the salt to make an acid and then burn one end of the can off'. The other two quickly point out that while this is clever, it will likely ruin the contents of the can...

The quant says, 'let's make a simplifying modeling assumption.... let's begin by assuming that we have a can opener'.

King of Ruperts Land's picture

To bad they did not have a "practical man": Find a large flat stone and rub one end of the can on it, an end with the "crimp". This will quickly grind through the very small part of the metal lid that is bent over the crimp around the edge and open the can.

By the way, real food does not come out of a can. With some effort, it appears on the end of pointy sticks and bleeds.

Next lesson. Fire from sticks and tinder.

King of Ruperts Land's picture

Market players now are like flies jumping from turd to turd in a flushing toilet bowl.

Gobble D. Goop's picture

Put shit in a hat.  Turn the hat over.  Shit falls out of the hat.  Applies to quantitative analysis as well.

Keep stackin.

BBB

ThePhantom's picture

things are going to change fast now... buckle up neo, the war has begun. our tools are replacing us. we are becoming them and they are becoming us? football this or football that? good luck . -the resistance

ich1baN's picture

Factor-based investing has been around for some time but the great thing about the market is that if one form becomes too dominant, then alpha crops up in another method of investing. 

In other words, it is more of a pendulum shift from one method to another or between multiple methods. Morgan Stanely has written a pro-article for both Quant and Fundamental b/c they happen to employ both strategies en masse - so it is no wonder they are promoting both strategies in a quasi combined strategy. 

At any rate, if too many depend on quant strategies that will always create value in strategies ignored. Fundamental strategies will gain the more traders and firms crowd into Quant, b/c price will fall to a rate that then becomes attractive to invest in, despite what a factor based model (a multi-linear regression) tends to spit out based on the relative risk premium one can pick up by investing in the industries with the highest slope (factor). That's the beauty of the market, correlations are always changing, and so are valuations and attractiveness. 

In short, there are 3 classifications of investors: Traders, speculators, and long-term investors. The tactics one uses to do any of these three will influence price to the degree money flows to them, but the return one would expect to receive while employing any one tactic under one of the 3 categories will be a diminishing marginal return, therefore giving other methods/tactics a higher expected return as the price of one tactic becomes overvalued and the price of securities that are valued according to another tactic become undervalued.

any_mouse's picture

If a strategy confuses you, you are the mark, and you should back away.

At the least, keep what you have.

Herdee's picture

She'll be a real shit-show this December.