How much longer can the US expansion last? At 96 months, the current recovery is already one of the longest on record. Another year and half and it will break the all-time mark set by the banner expansion of the 1990s. Still, based on the indicators we monitor most closely for recession risk, QMA now considers the odds of a downturn before the end of 2018 to be low. As QMA's Q4 2017 Outlook & Review discusses, this "To Be Continued" theme is part of the reason the Asset Allocation team has a moderate overweight in stocks and other risk-based assets after having recently added exposure to US value, financial and small-cap stocks, which we view as due for a catch-up in relative performance, particularly now that tax reform appears back on the front burner.
Market ViewMarket View
Compared to how we began the year, with hopes for a major boost from Washington and inevitable surge in US GDP, the first six months of 2017 would have to rate a major disappointment. Political headwinds have greatly reduced expectations for fiscal stimulus and the US is back to bumping along at its post-financial crisis new normal of 2%. Hiring has been robust but wages essentially flat. Profit growth has been strong. However, inflation has actually backed up a tenth of a percent or two. So, why then has the US stock market already gained nearly 10% for the year? As QMA’s Q3 2017 Outlook & Review discusses, it gets to one of the old adages of investing – that sometimes no news is good news.
QMA provides its economic and investment outlook for the second quarter. Based on purchasing manager surveys, one would have to conclude that the global economy has started 2017 on a solid note. The latest surveys are at a three-year high, consistent with global growth of about 3.5%, a very good number. In the US, however, a disconnect has emerged between the surging survey data and lagging hard economic data, with early reports indicating US GDP growth for Q1 of just 1%. The strong rally in risk assets continued in Q1, but some rotation was seen within markets, with US equity sector, style and market cap performance taking a more defensive turn and interest rates once again becoming range-bound.
QMA provides its economic and investment outlook for the first quarter. We believe that after several years of slowing growth, 2017 looks to end the deceleration trend, as the US once again becomes the lead driver of global economic activity. Donald Trump’s US presidential victory and promises of pro-growth policies are likely a game changer in that, at least in the near term, they finally break the economy out of its “lower for longer” rut.
(Journal of Investment Management, First Quarter 2017) One of the most crucial and challenging jobs investors have is deciding, based on the various forms of available ex poste measurements of manager performance, which funds are most likely to outperform ex ante – i.e., in the future. This study aims to improve investors’ chances of choosing successfully. To start, it narrows the analyses used to select top funds to two processes: 1) ranking fund managers according to skill (defined by the intercept in a regression of past returns on the five Fama-French factors), and picking the high-skill funds with the highest active share; and 2) ranking funds according to past-36-month Information Ratio (IR), and then selecting the most diversified of these top-IR funds. The study provides evidence that both approaches lead to selection of funds that are, on average, able to beat their benchmark net of fees in the subsequent year, with the top-IR diversified funds producing slightly higher levels of outperformance with lower risk of drawdown. These results stand in contrast to the typical fund which underperforms its benchmark by over 100 bps in the subsequent year. However, to correct for the problem that high IR can be associated with low return but even lower tracking error, the authors also introduce a new measure, Modified IR, to account for an investor’s desired alpha. The study finds that top Modified IR funds that are also diversified represent the ultimate “winner” funds – yielding a significantly better return than concentrated top Modified IR funds.
(Journal of Investment Management, Third Quarter 2014) We investigate whether large stock price changes are associated with short-term reversals or momentum, conditional on the issuance of analyst price target or earnings forecast revisions immediately following these price changes. Our study provides evidence that prices of stocks exhibit momentum when analysts issue revisions after large price shocks, and suggests that the initial price changes were indeed based on new information. In contrast, when price changes are not followed by immediate analyst revisions, we document short-term reversals, indicating that the initial price shocks were likely caused by liquidity or noise traders. A trading strategy that is based on the direction of the price change and the existence of analyst revisions in the same direction earns significant abnormal monthly returns (over 1%).
(Journal of Asset Management, January 2014) We present a model of expected returns when assets have different betas in up and down markets. Our model provides a useful perspective on what systematic risks are and how they are priced. Empirical evidence shows that contemporaneous stock returns are strongly correlated with downside betas, but weakly correlated with upside betas.
(Journal of Portfolio Management, Spring 2012)This study examines the immediate and delayed market responses to revisions in analyst forecasts of earnings, target prices, and recommendations. Consistent with prior literature, revisions in earnings forecasts are positively and significantly associated with short-term market returns around the revisions. However, we show that short-term market returns around target price revisions and recommendation changes are even stronger. We also find superior future performance (return drift) for portfolios that use information from all three types of revisions to those using information from only one of the three types of revisions.
(Journal of Portfolio Management, Spring 2008)An alpha indicator can lose its efficacy if too many investors use it in their trading decisions. Thus, a robust alpha factor model should consider how much of the information in a signal may already be reflected in stock prices.
(The Journal of Investing, Spring 2007) In a well-diversified portfolio, relaxing the long-only constraint should not increase the downside risk of portfolio alphas. This is likely even if the underlying stock selection strategy has a bias toward stocks with negatively skewed returns.
(Financial Analysts Journal, May/June 2004) Not all insider sales are the same. The percentage of shares owned by insiders is useful for predicting future returns following insider purchases.
(Journal of Investment Management, Fall 2003) All enhanced managers control tracking error by diversifying and controlling factors exposures. Once these variables are controlled, the excess returns of these managers have remarkably low correlations, even among those following seemingly similar strategies.
(Journal of Portfolio Management, Winter 2003) Might investor overconfidence systematically bias stock prices and create investment opportunities across different countries and different cultures? Valuation theory is used to suggest where such biases are most likely to occur.
(Financial Analysts Journal, March/April 2003) Though recent research regarding trading volume suggests the existence of an exploitable deviation from market efficiency, we show that, after earnings-related news and a stock's growth rate have been controlled for, the interaction between momentum and volume largely disappears.
(Financial Analysts Journal, July/August 1999) A probe of the consequences of behavioral biases in the context of valuation theory.
As more investors seek new sources of returns less correlated with the downward swings of the equity and bond markets, liquid alternative strategies have emerged as one of the more viable, and popular, investment options. Investors and their financial advisors are conditioned to select managers based on the asset class they invest in, frequently a less important consideration when assessing liquid alts than what they were designed to do. This has led to a certain amount of buyer’s remorse, with many people failing to understand why their strategies haven’t kept pace with the broader equity market. QMA looks at how the broad classifications used by retail databases can themselves make it harder to find the strategies that best suit an individual’s portfolio.
Since the wake of the financial crisis of 2008/2009, the funded statuses of public and private defined benefit plans continue to struggle. With limited capacity to absorb further capital losses, plan providers are seeking innovative solutions that manage drawdown risk and improve the health of their plans. QMA’s US Market Participation Strategy—with its asymmetrical return profile and low correlation to other growth assets—provides an effective solution for addressing drawdown risk concerns and minimizing surplus volatility (while still seeking long term returns). By incorporating MPS in their growth assets bucket, plan sponsors have the potential to optimize the trade-off between improving funded status during normal markets and minimizing surplus volatility during equity bear markets.
Of all the variables the new administration brings for investors one of the trickiest to plan for is inflation. Inflationary pressures were already building before the election ushered in the prospect of a sweeping agenda of pro-growth fiscal and de-regulatory policies. One common way to hedge against inflation is to diversify portfolios with exposure to real assets – including real estate, commodities, infrastructure and TIPS – that tend to perform better during inflationary periods. However, each of these categories reacts very differently depending on what form inflation takes. QMA analyzes historic returns during normal and above-average periods of inflation and makes the case for an allocation to real assets.
For much of 2016, many blue chip names lumbered well below their historical averages. At QMA, the valuation measures we use in our value strategies actually shift to favor cheaper stocks like these the more they fall out of favor. This contrarian streak means there are times, especially when value as a whole fares poorly, our strategies may fare a little worse. What is also means, though, is that when the cycle turns, performance can snap back dramatically. In our case study, QMA explores the value team's process that made for a difficult but ultimately rewarding 2016. This experience is an important reminder of why investors should stay committed to value and also what sets our approach apart, showing the efficacy of our model, particularly in market environments where our competitors' strategies are performing differently.
In a world where alpha can seem scarce, active small-cap managers continue to outperform their benchmarks at an impressive clip. But why? Investors have a general sense small caps are riskier and less efficient, but how or if these characteristics contribute to more alpha opportunities remains unclear. At QMA, we think it’s critical to understand the sources of returns so that you can improve your chances of capturing them repeatedly. So we recently studied our own small-cap strategy and found that capturing alpha in small caps isn’t mysterious. It is largely the result of pervasive inefficiencies that create more pronounced mispricings that managers can regularly exploit, provided they have the skill and discipline to harvest it.
As 2016 winds to a close, many investors are now nervously eyeing the US Federal Reserve’s December open market committee meeting as the most likely timing of its first interest rate hike in a year. Some fear a less accommodative Fed could soon be the proverbial straw that breaks the back of a market currently trading at Price to Earnings of around 20 times trailing earnings. The concern is rooted in established theories that interest rates are negatively correlated with high stock price multiples. But is this right? QMA’s paper upends the conventional wisdom about the relationship between interest rates and equity valuations. Our analysis of the past 150 years of data shows that low rates are supportive of high valuations up to a point, after which further low rates are actually associated with depressed P/Es.
Recently, there has been a movement away from active management. The low fees charged by passive vehicles, coupled with the perception of poor performance by active managers, have been the primary drivers for this shift. In today’s low-return environment, investors continue to be sensitive to the impact of fees on performance. In QMA's paper, Passive and Active Fulfillment Choices, we discuss the performance characteristics of different types of US active equity managers in the large-cap space and examine the advantages of combining a quant approach with indexing. We also consider the implications for investors in target date funds and how these fulfillment choices impact retirement savings and income.
There is a widely held view that we are in a lower return environment with single digit returns on the horizon for equity markets. In these times, any additional return is particularly valuable. Active extension, equity long-short, and equity market neutral products can be attractive for investors at any particular time, given investors' varied investment objectives and needs. That said, each of the three categories of shorting-enabled products can help address distinct issues facing investors today. QMA’s paper describes how short selling allows investors to find alpha in often overlooked places, explains the three main categories of shorting-enabled equity products, and highlights the benefits of a systematic quantitative process.
Dynamic Asset Allocation Portfolio Manager Ed Campbell provides QMA's third quarter 2017 outlook for the global economy and markets.
Dynamic Asset Allocation Portfolio Manager Ed Campbell provides QMA's first quarter 2017 outlook for the global economy and markets.
Gavin Smith, Portfolio Manager and Strategist for the US Core Equity team, describes how short selling seeks to allow investors to find alpha in often overlooked places, explains the three main categories of shorting-enabled equity products, and highlights the benefits of a systematic quantitative process.
Can emerging markets still deliver value for investors? Watch QMA’s Rodolfo Martell, Managing Director, Portfolio Manager & Strategist, describe his firm’s approach to finding alpha in today’s volatile emerging markets.
Being a quant is much more than just data and crunching numbers, it’s about using finance to find opportunities. Learn more about this fundamentally-driven, systematic process from the people behind it.