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Is This The Start Of The Factor Crash That Morgan Stanley Has Been Warning About

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In the past few weeks, there has been much investor speculation whether the recent record crowding in factor investing would have an adverse impact on the broader market. As a reminder, just yesterday, JPM’s Marko Kolanovic called the low-vol (i.e., “tech”) factor a “bubble” which he compared to events during the dot com bubble to get a sense of the prevailing market exuberance:

For instance, the ratio of the S&P 500 technology to energy sector is now the same as during the tech bubble.

Commenting on the charts above, Kolanovic says is that “the bubble we are describing is expressed in equity factors (sector-neutral momentum and low volatility factors), however signs of this bubble can be seen in sectors’ performance as well” which as we showed yesterday, had pushed the divergence between growth and value stocks to unprecedented YTD levels.

Looking at the chart above, Kolanovic said that “Bonds, momentum stocks, and low volatility stocks rallied – pushing the valuation spread between defensive and cyclical stocks to a level 2x worse than during the peak of the tech bubble. This bubble will likely collapse, i.e. this time is not different.

He then went on to note what we pointed out last week, namely that signs that “certain segments of tech are trading at unsustainable valuations are supported by the record level of speculative call option activity and outsized gains in certain tech stocks (Figure 2).” Sound familiar? This is precisely what we wrote one week ago in Frenzied Traders Send Option Volumes To All Time High; Go All-In Tesla, Tech Calls

Most importantly, the JPMquant showed that the the divergence between low-vol/growth/momentum factors and value factors had reached levels observed during the peak of the dot com bubble.

In short, Kolanovic had a simple message to JPM Clients: stick with the max pain value-growth/low-vol convergence trade, as it’s just a matter of time before it finally makes money.

There is just one problem: while Kolanovic may finally be right, a recent note from Morgan Stanley’s Chris Metli suggests that any reversal out of the popular growth/momentum/low-vol factors and into value would hardly be a walk in the park and will be met with a very violent market reaction, one which could be far greater than the September quant crash, to wit:

there is a concerning shift in the relative volatilities of factors.  For all of 2019, Growth names became steadily less volatile than Value names – but this is now showing signs of reversal.  Any increase in volatility in Growth is concerning because there is a greater overlap with the long side of investor portfolios (while Value is more representative of the shorts), and higher volatility on the long side of books is more dangerous because it impacts a broader investor base (note the Oct/Nov 2018 unwind had higher Growth volatility).

If correct, what are the market implications:

A concerning dynamic is a recent breakdown in the correlation between the legs of different factors – i.e. the correlation between the long side of Momentum and the short side (and similar for Growth and Value) all fell in late 2019 into January 2020.  Previous big declines in correlation were December 2017 and September 2018 – notably before big market volatility events.  An increase in correlation instability like we are seeing now makes it harder for market participants to manage portfolios – and an increase in the rate of change of these correlations typically precedes higher factor volatility.

It is also worth noting that any factor unwind would happen in a time of record high hedge fund gross leverage. As MS noted, its prime brokerage “team has noted that gross leverage for L/S hedge funds is near historical highs, while positioning in some (but not all) factors is extreme – Growth versus Value looks particularly stretched.”

In other words, any sharp re-positioning moves in factors – such as the one we just observed in the broader market on Thursday morning – and which had an immediate and adverse impact on the market, could well be the start of the factor-induced crash that Morgan Stanley has been warning about for quite some time now. Keep a close eye on what growth/momentum vs value are doing, and if there is indeed a sharp reversal, it may be time to get out of dodge.

For those who missed Metli’s note previously, here it is again:

* * *

Authored by Christopher Metli, Executive Director of Morgan Stanley Quant Derivative Strategies

Investors largely shrugged off the factor rotation on Feb 4th as an isolated event, but it shouldn’t be dismissed – higher factor volatility is structural and is here to stay.  Funds are taking bigger factor bets, positioning is crowded, leverage is high, and factor correlations are getting more unstable – all of which mean that future rotations will occur again (probably soon), and will likely be violent.  While fully acknowledging that Fed liquidity is supportive of Growth stocks, it’s also true that the consensus believes the rally in Growth will continue.  As a result QDS thinks the bar is low for an unwind should the economy change in either direction – a growth scare is the worst outcome for most investors, but growth acceleration can be painful too.

In this environment investors should consider:

  • Replacing longs with upside calls in names that have rallied where volatility is low (i.e. stock replace, keeping upside but limiting downside)
  • Hedging against sharp moves lower in the most vulnerable areas of the market – Crowded stocks (MSXXCRWD) or Growth vs Value (MSZZGRVL)

First, investors should recognize that the sources of risk have been shifting over the last 10 years.  Factor volatility has been on a steady upward path since 2010.  This impacts everyone (not just quants) because how stocks rank on factor scores now account for an increased portion of the total dispersion in the market.

This increase in factor volatility is not a one-off event, it is a byproduct of HFs making bigger sector and factor bets than they were a few years ago.  As one example, the chart below shows the distribution of Value exposures for discretionary long/short hedge funds in 2010 and in 2019, per public 13F filings.  In 2010 HFs leaned short Value, just as they do now, but the distributions were much more tightly clustered around the mean.  Today there are more funds in the tails running big overweights and big underweights.  This trend is not limited to just Value or even factors – the distribution of overweights / underweights across sectors is also wider than it used to be.

At the same time that factor and sector bets are getting bigger, funds making those bets are doing so in increasingly similar ways.  QDS has found that within groups of hedge funds with similar styles, investor portfolios are getting more similar to each other.  Similar portfolios means an increased risk of funds trading the same stocks at the same time.

Looking more recently, there is a concerning shift in the relative volatilities of factors.  For all of 2019, Growth names became steadily less volatile than Value names – but this is now showing signs of reversal.  Any increase in volatility in Growth is concerning because there is a greater overlap with the long side of investor portfolios (while Value is more representative of the shorts), and higher volatility on the long side of books is more dangerous because it impacts a broader investor base (note the Oct/Nov 2018 unwind had higher Growth volatility).

Another concerning dynamic is a recent breakdown in the correlation between the legs of different factors – i.e. the correlation between the long side of Momentum and the short side (and similar for Growth and Value) all fell in late 2019 into January 2020.  Previous big declines in correlation were December 2017 and September 2018 – notably before big market volatility events.  An increase in correlation instability like we are seeing now makes it harder for market participants to manage portfolios – and an increase in the rate of change of these correlations typically precedes higher factor volatility.

And then of course there is positioning.  The MS PB Content team has noted that gross leverage for L/S hedge funds is near historical highs, while positioning in some (but not all) factors is extreme – Growth versus Value looks particularly stretched.

The MS PB Content team put out an excellent note in November titled ‘O Factors, Why Art Thou So Volatile?’ which addresses a lot of these topics.  They find that higher gross leverage, a high level of crowding in the same stocks, and increased factor tilts has coincided with the increase in factor volatility over the last few years.  And importantly they find that it has tended to be L/S discretionary hedge funds, not quants, whose flows have most correlated to factor volatility in the last few years.  Contact your MS PB salesperson for the full report.

Trading Implications

Fundamental traders with concentrated portfolios should consider replacing stretched longs with call options, retaining the upside but minimizing downside risks.  The below screen shows top 100 S&P 500 stocks that are within 2% of recent highs – the upper left is where volatility is low and upside skew is steep.  For example names like ADP, CRM, and CHTR in the highlighted box below have call options that price relatively attractively versus history.

Investors should also consider hedging some of the factor/crowding risks in their portfolios.  In an unwind factor and thematic baskets can see an increase in correlation that means more downside making them good portfolio hedges.  QDS’s preferred methods are:

  • Short Growth versus Value (MSZZGRVL) given positioning for this factor remains stretched
  • Short the most Crowded stocks (MSXXCRWD) versus going long the market or long Technology against it (for less net sector exposure)

Timing future unwinds is of course difficult, but given the instabilities in the market highlighted above QDS thinks it makes sense to trim some factor risk in portfolios

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