How 3 Investment Styles Actually Translate into only 1 Factor
In the article titled “Mirror Image Factors Wiping out Quant Alpha”, asset management editor Rob Mannix discusses the challenges of constructing a balanced allocation to traditional equity factors.
The article looks at what can lead these factors to offset each other (momentum vs. value) or be additive (momentum and low risk). LFIS’ contribution includes the two first charts below which we feel provide a powerful visual summary.
In the first, each stock in the S&P 500 Index is represented by a blue dot. The x-axis ranks the stocks in terms of momentum (based on performance over the last 12 months skipping the most recent one) and the y-axis shows the ranking in terms of value (by earnings yield). The correlation between momentum and value ranks is -56%. The second chart ranks the same stocks by momentum on the x-axis and low risk on the y-axis (based on daily volatility over the last year). The correlation between momentum and low risk is 57%. A part of the significant dispersion in the returns of ARP funds in the recovery phase for the value style (third graph) comes from the fact that fund managers have likely either placed clear bets, whether on value for the big winners or momentum/low risk for those who suffered losses, or assumed that the factors will neutralize (i.e. the funds with flat performance).
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Sources: Bloomberg, LFIS. As of September 19, 2019. Panel of 24 Multi-Asset / Multi-Style / Long-Short Mutual Funds selected discretionary by LFIS as being the most representative.