Is this what a junk rally looks like?

Smart beta and factor investing have become very popular in recent years as a way to reduce fee expenses on equity funds while still capturing systematic risk premia that, in the long run, leads to outperformance over common stock market indices. The approaches to factor investing and smart beta are manifold, and this free book provides a good overview over the most common approaches and how to include them in the asset allocation of a portfolio. As a quantitative oriented investor, I am a fan of smart beta and factor approaches to investing because they impose discipline and an evidence-based approach to investments.

Thanks to a series of Hedge Fund Research (HFR) indices across different asset classes, these approaches to factor investing can now be tracked on a monthly basis and we can identify unexpected developments relatively quickly. And currently, something unusual is happening in the factor space. No factor works all the time so periods of underperformance or negative performance in factor approaches are to be expected. But there are some factor pairs that tend to have negative correlation with each other. For example, momentum factors tend to work when value factors don’t and vice versa. It is rare that momentum and value work at the same time. In the past, I have managed large cap equity portfolios and I used a factor-based approach focusing on value and quality to identify attractive investment opportunities. This was particularly helpful during the Eurozone debt crisis of 2011 and 2012, when the quality factor helped us avoid value traps in the Eurozone.

However – and this is something I cannot explain but only observe – in 2019, almost all factors seem to have stopped working. Our chart shows some of the most prominent factors used in the equity space. The smart beta index, which combines different alternative weighting schemes like equal weighted indices, minimum variance indices and risk parity approaches, has declined since early 2018 and is down 5.4% in the first three months of 2019 after declining 13.9% in 2018. Value and high dividend stocks have been struggling since late 2017 as well, and while in the first half of 2018, momentum performed well, this factor has seen negative returns since summer 2018 as well. Small cap and quality stocks have been underperforming for much of the last three years anyway, but their underperformance seems to have continued in recent months as well, after briefly stabilising in late 2018.

In short, we live in an environment where all the stocks that traditionally should be underperforming are amongst the best performing stocks. Could this be the ultimate junk rally where large cap companies with high valuations and low-quality earnings are the only game in town? And remind me, when did we see that before in stock market history?

Factor performance for global equities

Source: HFR, Fidante Capital.