Talk ‘22: ‘Staying the course is crucial’

“Well, it won't surprise you that I'm very bullish on quant investing. We have endured a harsh quant winter from 2018 to 2020.¹ This was characterized by strong performance from large-cap growth stocks, that our quant strategies typically don’t favor due to their value tilt. And of course, these large-cap names can continue to do well for a while. But this reminds me of the early 2000s, a period synonymous with the tech bubble. Similar to now, tech-related growth stocks embarked on a steep rally in the late 1990s, causing quant equity strategies to underperform, before they reversed their gains in the early 2000s. This was followed by a more ‘normal’ stage of quant equity performance.”

“A recent Robeco research paper highlights the cyclical variation in equity factor returns.² Equity factors typically deliver returns above their long-term average premiums during the normal stage of the cycle. But once in a while, which is roughly once every decade, this phase is interrupted by either a growth rally or a value crash, during which equity factors typically underperform. These periods are then followed by reversals, before we re-enter the calm, normal stage of equity factor returns. Historically, we have seen a few of these episodes. Blue-chip stocks surged during the Nifty Fifty era of the early 1970s, energy and materials sectors rallied at the end of the 1970s on rising commodity prices, and of course we had the tech bubble of the late 1990s. What these episodes have in common is that they were followed by reversals, and then a more normal stage of equity factor performance.”

“So, we have the impression that the prevalent large-cap stock rally driven by ‘big tech’ could be due for a reversal in the future. In our view, this is also confirmed by the valuations of factors which appear to be very cheap, while sentiment has also improved, especially for the value factor.³ We are already seeing a turnaround in the emerging markets (EM) space. Indeed, our EM-focused quant equity strategies have generally enjoyed a pick-up in performance this year. This is interesting because there is still a lingering feeling that quant equity strategies are still navigating a difficult period. But the picture has already changed within EMs. I also get the sense that investors are warming up to quant strategies again, as we are seeing increasing interest in our solutions. So quant investing is definitely the big thing to watch in 2022.”

“From a quant investing perspective, we do not foresee a permanent market impact due to Covid-19. We have of course witnessed increased volatility and trading volumes, as well as somewhat higher turnover during the March 2020 crash. But we have already observed situations like this in the past, like the examples I outlined earlier. The good news is that these periods have historically always been followed by a normal stage of quant equity performance. Using the tech bubble example again, there is often a belief that things are different and a new economy has arrived when we encounter periods like these. This has previously led to incorrect proclamations, including that value investing is dead. With hindsight, we know that value did recover from the tech bubble, and was one of the best-performing factors in the subsequent period, also within the IT sector.”

“So the main lesson for us as quant investors is that it is important to stick to our approach. This also allows us to capitalize on the recoveries in factor performance. For example, if we would have changed our strategy by lowering our exposure to the value factor given its publicized struggles, then we would have not benefited as much from the bounce in its performance in late 2020 and early 2021. So, this serves as confirmation that we have seen similar situations before and that staying the course is crucial.”

“Part of our research effort is focused on diversifying our approach through the use of alternative data and machine learning. The strict process we follow when testing new variables or methods is where we differ from most quant investors. While we acknowledge that some new data items might not have long histories, the coverage should at least be sufficient and span across multiple markets worldwide. The quality of the data should also be high enough, while variables have to pass our stringent tests. For example, they must exhibit strong standalone performance and survive numerous sensitivity analyses, including slight changes in variable definitions. Moreover, any new variable must add value on top of our existing enhanced factors. We often find that most variables fail at this stage of testing.”

“As an example, we have done quite a bit of work on intangible data such as goodwill and R&D in the past. We are now diving deeper and looking more at unstructured data, such as patent information including the number of patents registered by a company, or their quality based on citations. Some of the standalone results are promising. For instance, we observed that data on the number of patents are a good steer for sector allocation, however, they do not add significant value for stock selection purposes. On the other hand, the data on the quality of patents produced good stock selection results, but we found this was already captured in R&D data. Thus, this variable does not add more value on top of our existing ones. Our approach in using alternative data and machine learning is also somewhat different in that we use it for both return and risk predictions. In terms of the latter, we are looking at techniques that can help us to reduce our portfolios’ exposure to distress risk.”

“A topical issue for investors is sustainability. While we don’t view it as a challenge, it definitely is a game changer. There is a lot of momentum in terms of policies and regulations in this space, such as legislation on climate change, the Sustainable Finance Disclosure Regulation (SFDR) and the United Nations Sustainable Development Goals (SDGs), to mention a few. Investors are increasingly focusing on how to position their portfolios in respect to these developments. This can be related to just one sustainability dimension, such as carbon footprint reduction. Or they could look at an integrated multidimensional approach, that targets carbon footprint reduction with SDG integration and exposure to higher scoring ESG companies, for example. Investors could also investigate how they could best combine sustainability preferences with financial objectives.”

“Alongside this, we are seeing significant demand for strategies in which the tracking error budget is used only to cater to sustainability preferences. This speaks to our relatively new ‘Sustainable Core’ strategies. We believe flexibility in design and customized solutions are key, given that clients have varying financial and sustainability goals. The rules-based and systematic nature of our quant investing platform makes it suitable for the development of customized client portfolios. This is supplemented by our institutional knowledge in the fields of quant and sustainability investing. We believe this can allow us to offer the best possible solutions for our clients.”

“Investors are also thinking more about how to make an impact. We believe voting and engagement play an important role. Through these tools, shareholders can change or reshape corporate agendas. In one of our research papers, however, we illustrated that asset managers – particularly large and passive players – generally vote against most environmental and social proposals.⁴ So, there are still big steps for the industry to take in terms of voting. We expect increased attention on this front. In our view, the role of active and passive management is also crucial. This is because when engagements are unsuccessful, passive managers cannot divest from the affected companies as long as they form part of the index that they track.”

“Covid-19 has brought to light numerous concerns around personal limitations, many of which I’m sure most people can agree were inconvenient. For example, work-life imbalances spring to mind. Personally, I found the period of school lockdowns quite difficult to manage as a parent. This also coincided with the challenges we faced at work as a result of the market drawdown. On the flipside, however, the lockdowns also resulted in less business travel. All in all, I am grateful that I got to spend more time with my husband and three young boys. They have certainly given me a lot of energy and motivation throughout this time, and it goes without saying that I would like to keep enjoying the benefits of having more family time in 2022. Of course, we could definitely do without further school closures.”

“Broadly sticking to reduced levels of business travel would be welcomed in the coming year, along with the associated carbon reduction. On top of this, and on a more personal level, I would like to further reduce my meat consumption. While I have progressively done so over the past few years, my aim is to really bring down my intake to a bare minimum in 2022. Luckily, my kids are swaying me towards vegetarian alternatives.”

Footnotes

¹ Blitz, D., May 2021, “The quant crisis of 2018-2020: Cornered by ‘big growth”, Journal of Portfolio Management.
² Blitz, D., September 2021, “The quant cycle”, working paper.
³ Baltussen, G., Hanauer, M. X., Schneider, S., and Swinkels, L., September 2021, “What valuations and interest rates tell us about equity factors”, Robeco article.
⁴ Groot, de, W., Koning, de, J., and Winkel, van, S., June 2021, “Sustainable voting behavior of asset managers: do they walk the walk?”, Journal of Impact and ESG Investing.