The stock market may be getting too complicated to be left to ordinary money managers.
Active funds are having a rough stretch in 2016, with the proportion of stock pickers beating their benchmark falling below 25 per cent in one of the worst showings ever recorded. Money is being yanked at an unprecedented clip and being pumped into index funds and ETFs, where share selection is neutralized.
According to analysts at Nomura Securities, a bad year is being made worse because active managers did a particularly bad job policing their picks for secondary qualities that had the potential to alter returns, things like high cash balances or analyst coverage. Nomura joins a chorus of firms who say a greater focus on such characteristics - factors, in quant parlance - is needed in an industry trying to reverse years of underperformance.
"It's inexcusable to not be aware of the factor bets you're making," said Benjamin Dunn, president of Alpha Theory Advisors, which works with hedge funds overseeing about $6-billion. "If a risk can be measured and you can speak about it, you should at least have a reason for why you're choosing to take that risk."
Quantitative processes are having a star turn of late. Point72's Steven A. Cohen is committing as much as $250-million of capital to be managed by 5-year-old online platform where members build computerized trading models and earn a share of profits. Daniel S. Loeb's Third Point LLC hedge fund said in an investor letter Tuesday that factor risk is driving hedge fund underperformance in an up market this year.
In determining why a fund does well or poorly, there's a simple explanation and a complicated one. At a basic level, mutual funds struggled in the first half because they crowded into stocks that fell and shunned the ones that gained. Human managers were famously concentrated in mega-cap technology shares and owned fewer energy firms, choices that soured when oil rebounded and companies like Netflix slid.
As befits their mathematical bent, quants take a more analytical approach, looking for subtle, often hidden mistakes that cause stock picks to founder. One process they employ is factor attribution, which compares the earnings, valuation or price characteristics of a set of stocks to what worked in the market over a given period.
Say a fund manager is enamoured with value and likes to buy shares trading at a discount to earnings. But in his rush to own cheap shares, he inadvertently buys a bunch of companies with, say, weak balance sheets. He can be blindsided if market suddenly turns against companies with shoddier finances.
"Stock picking matters, sometimes more, and sometimes less. But the wrong factor exposures can undermine stock picking," Joseph Mezrich, managing director at Nomura, said. "It is very unlikely that managers know all of the unintended factor exposures in their portfolios."
According to Nomura, active mutual funds committed catastrophic factor errors in the first half of 2016. Growth managers owned stocks whose research budgets were particularly high and which the market killed in the first quarter. Core managers bought companies with high cash balances in the first half of the year - shares that fell 18 per cent.
For growth funds in the first quarter, "nine of their 10 highest positive factor exposures had negative returns, while all 10 of their most negatively exposed factors had positive returns," Nomura wrote. "Value funds have had terrible results in 2016. Their main active factor exposures and corresponding factor returns in the first half of the year show why: positively exposed factors had negative returns and negatively exposed factors had positive returns."
Like Bloomberg LP, Nomura sells tools to diagnose fund manager performance, and it may not be surprising that analysts on its quantitative investment strategy team see eliminating unintended style exposure as the key to maximizing gains. Still, in the first half of 2016, they say excess tilts were to blame for a big chunk of the losses among actively managed portfolios.
To be sure, every factor that creeps into a portfolios isn't harmful to returns. Take a growth manager who also ends up making a bet on profitability - those two factors could easily combine to enhance gains. But active managers ran into trouble this year because nearly every extra bet, intentional or not, fell flat.
Value managers' biggest additional factor exposure was to companies with higher return on invested capital. That strategy sank 4.6 per cent as normally bullish harbingers like buybacks and activist interest didn't work in the first half of 2016. Meanwhile, value funds were tilted away from the few strategies that paid off, such as dividend yield, which produced an 8.9-per-cent return, according to Nomura data. The S&P 500 gained 2.7 per cent over the same period.
While it may be unrealistic to completely strip out all secondary style tilts, knowing what you own is helpful when factor performance starts to shift, said Mr. Mezrich.
"The awareness of the unintended factor exposures could point to obvious offenders to remove or stocks to include to adjust the portfolio exposures," he said. "If things are not obvious, but there are large unintended exposures, then reducing tracking error could be useful."
It'a no surprise that value and growth managers got blindsided, according to Abhra Banerji, director of quantitative research at Evercore ISI. In an environment where low-volatility and dividend-yielding stocks have been two of the few money-making strategies, other factors have above average correlations, making it difficult for investors to fight off unintended exposures, he said.
"I don't think they're being careless. It's a consequence of the moves we've seen," said Mr. Banerji. "Post-Brexit, we've seen some of the highest and weirdest correlations, like between momentum and low volatility."
Even if managers had weeded out excess factors, they still likely would have seen disappointing results year-to-date. In a long-short strategy that gives you pure exposure, value and growth would have fallen 2.4 and 1.4 per cent through July 26 respectively, data from Bloomberg's portfolio analytics tool show.
"There are a lot of global macro risks, and all of those are powerful determinants of returns in a world where value and growth are muted," said David Bechtel, principal at Stamford, Connecticut-based Barrow Street Advisors. "That allows other factors to dominate returns."