This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article features Benjamin Lavine, chief investment officer for 3D Asset Management.
With small cap value having made a sharp comeback from the depths of the mid-March COVID-19 pandemic bear market, and Robinhood traders driving up both stay-at-home stocks and beaten-down consumer cyclicals (e.g., airlines), the “momentum” style of investing experienced a deep drawdown in early June that has partially reversed itself as of the time of this writing.
With the threat of a second wave of COVID-19 active cases projected over the second half of this year, and the Federal Reserve casting a pessimistic economic outlook following this week’s meeting, we could be setting ourselves up for a second wave of “momentum” outperformance alongside “low volatility.”
As we observed in our “Factor ETFs For Diversification Or ‘Diworsification?’ and “The Year Smart Beta Died?” articles published last year on ETF.com, this has been one of the more challenging periods for factor-based (aka smart beta) investing, except for “growth,” which continues to beat the pants off other factors, despite its long-term subpar performance (see below) and 2020 continues that trend so far.
Figure 1 displays the Bloomberg US Pure Factor performance year to date through June 10, 2020. Note: Bloomberg US Pure Factors represent theoretical noninvestable long/short baskets designed to capture the specified factors. A net positive return implies the factor is outperforming and vice versa.
Figure 1: US Growth Factor Performs Consistently So Far This Year While All Other Factors Have Experienced Reversals Post COVID-19
“Momentum” had been performing moderately well alongside “profitability” throughout the March market sell-off as investors sought the high ground of certain profitability and positive sentiment that would likely survive a post-COVID-19 world order. These factors then continued to perform reasonably well throughout the market recovery in April and May.
Then in June, we witnessed a sudden reversal of both factors as investors chased out-of-favor COVID-19 victim stocks across consumer and industrial cyclicals in anticipation of a sharp economic recovery from pandemic self-quarantines.
“Momentum” performed worse than “profitability,” as the former tends to be more volatile versus the latter, as the “losers” have run well ahead of the “winners,” likely a result of short covering. “Low volatility” had also fallen out of favor, with the renewed risk-on sentiment, and has performed even worse than “value” so far this year.
Indeed, it appeared as if the shine had started to come off this favored style of investing commonly employed by both institutional hedge fund and retail investors alike, even with FAANMG popularity and the Nasdaq-100 reaching new highs.
As is indicative from Figure 1, the “growth” style of investing remains preeminent over all other factors, and has actually turned positive over the long run, especially when juxtaposed against a significant five-year drawdown in “value” (see Figure 2).
Figure 2: US Growth Factor Turns Positive Over The Long Run Juxtaposed With A Significant Drawdown In Value
There were multiple signs that “momentum” appeared to have been overbought and overcrowded, as “value,” “dividend yield” and “low volatility” had fallen out of favor. Figure 3 displays a chart from MSCI measuring factor crowdedness as indicated by factor valuation spreads, short interest spreads, correlations and other technical measures.
Even with the June sell-off, “momentum” shows up as significantly crowded, driven by historically wide valuation and short interest spreads. On the other side, MSCI shows “value,” “yield” and “beta” (an inverse of low volatility) as out of favor.