“There’s an app for that,” so goes the buzz-phrase, which was created and later trademarked by a technology juggernaut. The expression describes a software revolution found inside smartphones and tablets. Now, as quantitative strategies pile into portfolios, investors will probably start saying, “there’s a quant for that”. The idea behind ‘quantitative strategies’ is to make investment decisions based on algorithms or some other form of automated, computer-driven model. This can take the ‘art’ out of the investment process, which isn’t necessarily a good thing.
Traditional stock trading volume by banks and asset managers has been declining over the past number of years. The slack, however, is being picked up by quantitatively focused trading firms. In the hedge-fund business, net money flows into quantitative strategies rose $13 billion last year whereas traditional strategies experienced outflows of $83 billion. Smart beta ETFs (a term used to define quantitative investment selections) is another area of growing popularity. Their assets under management have quintupled in the last decade.
An example of a quantitatively-focused strategy is trading based on market volatility. It is a common belief that growth stocks exhibit greater price variation than value stocks. A strategy executed by institutions is then to purchase value stocks with borrowed money when financial markets are calm and lending conditions are ripe. This strategy can enhance returns and limit downside risk. However, when financial conditions are tighter than average, impediments to borrowing make it harder to buy securities on margin. The next best option for returns is to purchase growth stocks.
To see the volatility strategy in action, look back to the last financial crisis. The Chicago Fed National Financial Conditions Index reports that liquidity and leverage conditions were tighter than average surrounding the deepest part of the recession. During this period, large-cap growth stocks outperformed large-cap value stocks by almost .4% per month. Since then, financial conditions have been looser than average and the out performance of growth stocks has narrowed to an average of roughly .15% per month.
“EXCHANGE-TRADED-FUNDS AND QUANTITATIVE INVESTING ARE REVOLUTIONIZING TRADITIONAL STOCK PICKING.”
Another common quantitative strategy strives to time market cycles. For example, momentum strategies (the idea of buying investments with recent strong performance) are found to do well in complacent markets and poorly in turbulent markets.
Exchange-traded-funds and quantitative investing are revolutionizing traditional stock picking. Historically, many of the large money managers avoided quantitative research and rather focused on fundamental analysis. Fundamental research involves scouring financial statements and speaking to customers and management. But, as the popularity of quantitative trading increases, returns will certainly diminish as large amounts of money chase the same thing. Someday as this happens, traditional fundamental analysis can regain popularity.
However, certain fundamental analysis techniques have seemingly led to consistently strong investment performance. For example, dividend yields plus share buyback yields have revealed a close fit between stock market performance and overall economic growth.
Therefore, it can be interpreted that income growth is fundamentally important to future stock market returns. According to Yardeni Research, the income yield from dividends and share buybacks of the largest 500 US companies resides around 5% per year. For now, the income yield likely represents the future return expectation for stocks and a benchmark that quantitative firms will attempt to overcome. The point is that just because a particular investment approach works today, it doesn’t mean that same methodology will work forever. Markets and investors adapt.
MARKET MOVERS
Foreign Equity was the winning category in the month of May. Foreign stocks are also the hottest category in 2017 with year-to-date gains over 16%, compared with roughly a 4% return for US Equity. Global monetary stimulus and improving economic activity are offering a stable climate for investments. The Core Allocation models continue to outperform their benchmarks, Morningstar World Allocation and Morningstar Tactical Allocation. The Investment Team’s decision to increase portfolio exposure to emerging market equity is a big contributor to the strategy’s strong performance. The Investment Team continues to monitor the volatility of equity prices, the direction of commodity prices, and geopolitical headlines as events unravel. Despite a few recent currency and corruption scares in emerging economies, money continues to flow into emerging stocks.