As the recent quant thread on Zero Hedge has stirred a firestorm of interest into this arcane field of finance, I present an interesting academic paper courtesy of Dr. Vinay Nair who previously worked as a PM and Research Director with none other than Vikram Pandit at Old Lane, and author of Investing for Change. Nair looks at the performance of two primary quant strategies during recessionary times: Momentum (Up Minus Down as defined by Fama French) and Value (High Minus Low) to determine how quants fare in odd times such as these. As Mr. Nair shares with Zero Hedge:
Momentum (as defined) is one of the most popular (and crowded) strategies in the quantitative equity market neutral space, and, as the research note shows, loses out in bear market rallies or recovery rallies. Combine this fact with the increased importance of quant trading in markets and I would expect to see sharper rallies than in previous cycles (Market goes up > momentum suffers > quant guys liquidate momentum > market goes up further).
This is yet another datapoint indicating how technically self sustaining the market may get until there is terminal pain for key liquidity providers as they increasing shift to avoid orderly market strategies and programs.
In his report, Nair states:
In order to generate returns to value and momentum factors, we rely on the most widely used proxies, first generated by Ken French and Eugene Fama. The Fama‐French version of Momentum is known as Up Minus Down (UMD). The Fama‐French version of the Value strategy is called High Minus Low (HML).3 For purposes of a benchmark, we also include the strategy of investing in the market and selling Treasury bills (MKT). Ken French maintains a data library with returns to their versions of each strategy from January 1927 till February 2009.
However, when we consider performance during recessions, our conclusion shifts. Not surprisingly, investing in the market is a painful experience during recessions with an average return of ‐8.73% and volatility of 28%. Value performs similarly ‐ with returns falling to 1.51% and markedly increased volatility, the IR becomes an unremarkable 0.09. Momentum, on the other hand, holds up rather well with similar returns in expansionary and recessionary periods. The strategy does become volatile, thus causing the IR to drop but remain at a healthy 0.36.
All of the negative market exposure of momentum is concentrated during recessions, with both the up and down market exposures becoming ‐0.32. Outside of recessions, the strategy has no real exposure to rising markets and a positive exposure of 0.26 to falling markets. This suggests that much of the diversification benefit of investing in Momentum occurs during recessions. In stark contrast, Value’s low beta behavior disappears during recessions. In recessions, Value’s beta to falling markets becomes 0.14, precisely when one would not want it.
The current recession has seen these strategies behave as expected. Figure 1 plots an investment made at the end of 11/2007, right before the NBER start date for the current recession. The overall market has been a terrible investment, particularly since the beginning of 10/2008. Value returns were relatively stable and did well prior to 10/2008, rising 9% in three months. However, as the market began substantial declines in October, the strategy began to move more closely with the market and lost 25% over the next five months. In contrast, Momentum has performed relatively well, with annualized returns of 22% at 20% volatility throughout the recession.
However, we also haven’t seen significant bear market rallies or recoveries in this sample (the data from Ken French does not yet include March 2009). One would expect momentum to give back some gains during these rallies and during the period of recovery in equity markets.
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