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A $1.5 Trillion “Quantamental” Market Opportunity

Courtesy of ZeroHedge. View original post here.

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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