Value vs momentum | Feature


HIGH FREQUENCY TRADING But these longer term trends fall short in explaining why the demand for factors shifted so suddenly. One potential explana- tion for the sudden movement might be the impact of high frequency trading. Damian Handzy, chief commercial officer at Style Analytics, believes that it could have played a role. “Algorithmic trading strategies, like those used in high frequency trading, take advantage of mean reversion and momentum. This combination can exacerbate dramatic market movements by pumping momentum gains and then sud- denly reversing course - driving markets in the opposite direction back to the mean. This new phenomenon poses a threat to factor-based investing because it has the potential to disrupt established relation- ships and undercut fundamentals.” BT’s Wyn Francis also backs this view. “The sharp nature of the reversal does suggest that quantitative strategies played a role, especially in the crowded momentum stocks,” he argues. But de Koning dissa- grees. “High frequency trading has been around for many years so we doubt that these trading strategies accelerated the per- formance of value and momentum factors early September. Also, we have been involved in factor-based investing for more than 25 years and the sudden strong perfor- mance of value, momentum or quality fac- tors have occurred many times in the past, so the influence of high frequency trading might be a bit overstated.”


Thomas Stork also disagrees that the sud- den shift could be caused by high frequency trading as such but acknowledges that pas- sive investing more broadly, rather than just factor investing specifically, may have contributed to investments concentrating in some sectors of global equity markets. A consequence of the rising awareness of factor investing is that firms are increasingly being analysed in a factor framework, Stork highlights. “Think about the reclassifica- tion of some of the IT names into commu- nication services. That in itself changes the narrative,


even though the companies


haven’t changed their performance profile.”


The growing impact of passive investing is also a concern for Francis. BT Pension Scheme, which manages more than £50bn, has recently reduced its exposure to factor- based investment strategies to 34%, com- pared to more than half of its equity portfo- lio last year. Instead, it now aims to focus actively-managed equity strategies. Francis predicts that the flow of assets into passive and factor strategies has now created mar- ket inefficiencies and opportunities for active managers. He also highlights that technological change could potentially cre- ate significant risks for strategies which are constructed on a backward looking basis. ESG is another concern for the pension scheme. “We find certain factor strategies, such as value, negatively impacting ESG scores and carbon intensity,” he adds.


THE IMPORTANCE OF DIVERSIFICATION


While investors appear divided on what caused the sudden change in factors, most believe it is yet too early to celebrate the comeback of factor investing. Wyn Francis believes that given the environment of lower economic growth, investors are will- ing to pay a premium for growth stocks, a


trend which has been reinforced by robust earnings growth. While he believes the eco- nomic outlook is likely to remain mute and interest rates will remain low, more muted earnings growth could potentially trigger growing demand for value. Two key lessons emerge for investors from the recent rotation, one is to avoid trying to time the market with factor strategies, the other is to maintain a diversified portfolio which


includes multiple factors. For


Andrew Peach, principal consultant at Aon, this is a key message for investors to take home. “We think that the most sensible way to work around that is to have a diversified multi-factor exposure, some- thing that delivers attractive risk adjusted returns through the entire market cycle.” De Koning adds to that: “The sudden shift between value and momentum just under- pins the importance of on the one hand not actively engaging in factor timing,


the


selection of and trading between different factors.


“It also demonstrates the importance of diversification over multiple proven factors as it is difficult to forecast when and how strong certain factors will perform in the future.”


Issue 88 | November 2019 | portfolio institutional | 49


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