Wall Street quants can’t agree on risks

Conundrum gains urgency on warnings that markets are entering a new era of tighter global liquidity

Wall Street quants are taking sides on the trajectory of the US business cycle — and money is riding on their investing styles like never before.

The high-stakes call — risking some of the stock market’s hottest trades — is reigniting one of the most contested debates in the quantitative community: Can investors time the market? And even if so, should they?

It’s all down to conflicting economic signals in factor investing, which slice and dice equities by their traits like value, volatility and growth. As warnings snowball that markets are entering a new era of tighter global liquidity, the conundrum has gained urgency.

In the green corner is Bank of America, which argues US markets are in the throes of mid-cycle expansion. That is, when “macro indicators are generally above average and improving.” If the strategists are right, riskier factors like momentum — wagering on stocks with the biggest gains over the past year — will power quants’ moneymaking engine going forward.

In the red corner are Sanford C. Bernstein analysts. They cite the outperformance of quality factors like low leverage as a signal that developed markets are engulfed in late-cycle angst. If their bearish prognostications come to pass, some of the most popular bets on market leaders like technology shares are headed for danger.

Conflicting signals

For now, there’s data to back up whichever group of quants you believe. Volatile and momentum equities have continued to notch gains, lending credence to the Bank of America mid-cycle thesis. On the other hand, cheap value shares and those with high leverage have slumped — both characteristics of latecycle dynamics.

This is far from an esoteric debate for math geeks. A record swath of the global investment community will be affected by structural shifts in factor performance. About 20 per cent of managed US stock assets reside in quantitative strategies, and effectively up to 40 per cent in passive, according to JPMorgan Chase & Co.

“The centre of gravity has been shifting from a primarily active fundamental approach to more of a quantitative/passive approach that should be primarily analysed through a factor-driven framework,” strategists at the US bank headed by Dubravko Lakos-Bujas wrote in a Friday note. “As a result, the role of factor analysis has gained increasing importance within the investment process.”

Market clock

Factor timing has also grown popular as quants in a relatively crowded field try to squeeze out alpha, or outperformance, despite scepticism over the strategy. AQR Capital Management, for example, has long argued that it’s unwise to pop in and out of factor investments merely based on valuation.

In a blog post last month, the firm posited that macro factors can’t explain the slump in value stocks across the board. For example, a stock may be cheap either due to weak growth prospects, poor management, or high debt levels. In each scenario, the equity would react differently to say, high inflation, AQR argues.

A record swath of the global investment community will be affected by structural shifts in factor performance. About 20 per cent of managed US stock assets reside in quantitative strategies, and effectively up to 40 per cent in passive.