We certainly know that contrarian valuation-based factor timing tilts are low Sharpe ratio strategies (very low short-term, somewhat better medium- to long-term) that are rarely immediately rewarded (few have such timing luck). 2 2 Close Though, despite bitter experience, the day after you put on such a tilt part of you does come in to the office genuinely expecting it to start working ASAP. We are all that naïve… Thus, as you’re all likely well aware by now as we keep repeating ourselves, we recommend “sinning a little” and only doing so at extremes. We wrote about (and implemented in the appropriate places) such a timing sin late last year, moving to a small overweight of the value factor (remember – value is only a part of our process). We only sinned a little (thank God for small favors!). Again, while we know such tilts are rarely, if ever, instantly rewarded, it’s also rare for them to be instantly incredibly punished (simply because “incredibly punished” is, thankfully, a rare thing). Well, welcome to 2020.
To get a sense of the magnitude, let’s start with the most basic data. 3 3 Close To keep this simple, and because the message is the same, I only address the USA here. But the extreme value drubbing this year-to-date is a global phenomenon (Europe terrible, emerging markets terrible, Japan merely bad). I’m confident that were we to assess the rarity and extremeness of this year-to-date globally the results would be even more extreme than I document here. Also, the data here ends on Feb 13th. Updating it through today would be still worse. Take the Russell 1000 Growth and Value series starting in 1991. We consider this a pretty simplistic form of value investing, but it captures the core concept and is widely followed. From January 1st until February 13th of 2020 the cumulative daily return difference between the two is -6.4% (take a guess which one of the two was worse 4 4 Close It rhymes with “schmalue“.} ). Comparing this period to all rolling periods of the same number of days going back to 1991, this difference falls below the 3rd percentile. Of course, that includes such famous events as the technology bubble of 1998-2000 and the GFC of 2008-2009. If you only look at 2010 to today, this is the zeroth percentile event. That is, in a decade quite bad for value investing, the start of 2020 is the absolute worst 6-week period. 5 5 Close It’s not precisely six weeks but I’m going to call it that as it’s very close and much simpler to write.
Doing the same comparison among small stocks (Russell 2000 value vs. growth) from 1993 onward yields nearly identical results. Now, if we use Fama and French’s HML (using AQR data as Ken doesn’t update fast enough for this!), it’s a bit more extreme. This 6-week period falls below the first percentile since 1963 and, of course, is the worst such period since the value drawdown began a decade ago. 6 6 Close It’s really “more extreme” only because we can go back to 1963 and thus the value destruction in the tech bubble and the GFC gets less weight. Using AQR’s preferred method for measuring value, using more updated prices, which we call HML-Devil, it’s been much better at exactly 1st percentile bad since 1963. Take that, dissertation advisors! 7 7 Close Hopefully it’s clear that is self-deprecating sarcasm, not bragging. They are pretty much the same. Adjusting HML-Devil for industries, something we’ve advocated since 1994, creates an exceptionally mild improvement. This value strategy comes in at only the 1.4th percentile back to 1963 and is off the zeroth schnide at 0.3th percentile in this ten-year value drawdown (it’s only not the zeroth because of a worse rolling period a few days earlier!). 8 8 Close Adjusting for industries was actually helpful from 2010-2017, but not in the last two years (a minor part of why we prospered during value’s troubles from 2010-2017 but have suffered along with it afterwards).
Taking a large jump in complication, and we hope efficacy, AQR’s long-short value factor, our most proprietary version of value using our preferred mix of indicators and construction methodology, has sadly fared quite similarly. Its YTD 2020 performance ranks in the 1.5th percentile back to 1984 and the 0.7th percentile against same length periods since the general value drawdown began in 2010. This version of the value factor did indeed help us a lot from 2010-2017, a big contributor to why this was a good, not a bad, time for us despite value’s more general suffering (yes, I will keep reminding you we are still on an under two-year drawdown while most forms of just value are on a ten-year one – how long two years actually feels, versus how long it really is economically and statistically, is a monster issue in investing). As we have written about before, these (we believe) better versions of value have helped long-term and during most of the value drawdown. But they have decidedly not helped during these last two years. We, perhaps self-servingly, but backed by a fair amount of evidence and logic, think this is because the value drawdown from 2010-2017 was largely “rational” (the air quotes are because that’s always a loaded word), while that from 2018 to the present seems decidedly less so (and a very “irrational” loss for value is the environment we’ve never found a great way to hedge against as many other factors like profitability and fundamental momentum don’t help much, if at all – by the way, we saw this exact pattern, factors that normally help when value falls, not helping during the tech bubble). 9 9 Close By “irrational” versus “rational” here I mean that value (or any strategy) can win or lose for at least three reasons. One, positive or negative carry which isn’t crucial for the distinction I’m making here as it doesn’t explain short sharp moves but rather long-term expected returns. Two, prices move for or against you because beliefs or sentiment changes. That can be rational or irrational depending on whether the updated beliefs are themselves moving towards or away from rationality (and yes, I’m clearly implying they’ve moved away lately). Three, the realization of actual fundamentals. If you buy a stock because it has a low P/E (not nearly enough to go on!) and both its price and earnings fall 50%, you lost big on the stock, but using your one (insufficient) measure it got no cheaper. You didn’t lose on a “cheapening” you lost on the fundamentals. Like this one stock example, the value factor (or any strategy) can win or lose on the fundamentals coming in better or worse than what’s priced in even if valuations don’t change. We believe that, very broadly speaking, value lost for “rational” reasons from 2010-2017 and more (if not completely) “irrational” ones from 2018 onwards. Obviously we like the first type of value loss (and, again, we can prosper during a value loss!) a whole lot better. As I mention in the body of this piece my colleagues have a very nearly done paper that examines this in great depth.
The point is a simple one. Value has started 2020 with an extremely severe loss versus very long-term history, and, defined in a wide variety of ways, the worst loss yet (examining all of the same 6-week length periods) over the entire long 2010-2020 value drawdown.
So, what are we going to do? Well, when it comes to making big changes to the process, very little. It would be a fair critique to say that this piece is largely just “quantitative whining.” First and foremost we’re executing our preferred strategy of not making panicky changes to our process that would have (note the tense) alleviated recent pain. Nothing has changed save value has gotten cheaper this year. We will continue to watch the value spreads, and consider doing a bit more of a tilt if they ever, which we hope not to see but will persevere if necessary, get to tech bubble levels, or conversely if they remain high but are running into less of a negative trend headwind.
I have been a pooh-pooher (if that’s not a word, it should be) of some who compare this current value pain to the tech bubble. We have found value spreads are quite wide today, but not tech-bubble wide. 10 10 Close You will come across some research that shows value is even cheaper than the tech bubble. We’ve generally found these pieces to be using fairly cherry-picked value measures over strange universes and using odd portfolio construction. It’s quite enough for us to be much of the way there without going full tech bubble… Though I have to admit, while you don’t come to me for my feelings about markets (I make no claim to be better than anyone else in this regard – and I don’t think anyone is that great!), I will say comparisons to the tech bubble, in terms of seeing more radical events (no more slow steady losses for value, now it’s very quick big ones!), and the widespread embracing by many of all the reasons (which they usually have never mentioned before) as to why value is never going to work again (my colleagues have a paper on this I hope to blog about soon), are converting me. It’s getting very bubbly out there (number two here details how I try to use this word as little as possible – but more than I would’ve when emerging from the University of Chicago many, many years ago).
Again, our plan is to do very little. That doesn’t mean we don’t question everything constantly (“doing very little” does not apply to research into what’s going on or trying, as we always are, to improve strategies). But, if that questioning doesn’t result in damning evidence (again, the paper by my colleagues is forthcoming!), it means sticking with the process.
We’ve seen this movie before a few times and we know how, but definitely not when, it ends. We believe that sticking with the process is the only way to achieve the long-term gains we seek (and which won’t always be provided by a long-only market that continues to levitate). We also know that sticking with something that’s good through its occasional very bad times, and even acting as a contrarian when others are finding newly created (and creative) reasons to throw in the towel, is very difficult. 11 11 Close I often go further noting that changing your process, not because you’re following some disciplined pre-specified plan (e.g., using trends, which we in fact do a bit in our alpha oriented multi-factor processes), but because you’re in pain (of course, you never say you’re changing because of the pain, it’s always justified with some ex post research) is the only -5 Sharpe ratio strategy (gross, there are plenty of -5 net strategies! – and, of course, please don’t take the -5 too seriously!) I’ve ever encountered (yes, this is an anecdotal observation, not data). If I could bottle it and do the opposite I would (it’s hard to bottle the precisely calibrated point of human caving/rationalization!). But this very difficulty is a large part of why we believe it’s long-term rewarded, and much harder to arbitrage away than some seem to think. As they say, if something were easy, everyone would do it. 12 12 Close It’s ironic that one of the reasons some say value won’t work anymore is it’s too crowded and everyone knows about it. Uh, no. It’s out of favor, hated, and cheap, even if widely known. If Yogi Berra was a value critic he’d say “that strategy is so popular nobody does it anymore.”
The views and opinions expressed herein are those of the author and do not necessarily reflect the views of AQR Capital Management, LLC, its affiliates or its employees.
Past performance is no guarantee of future results.
This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such.AQR Capital Management is a global investment management firm, which may or may not apply similar investment techniques or methods of analysis as described herein. The views and opinions expressed herein are those of the author and do not necessarily reflect the views of AQR Capital Management, LLC (“AQR”), its affiliates or its employees. This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and AQR to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. Past performance is not a guarantee of future performance.
This material is not research and should not be treated as research, and does not represent valuation judgments with respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not represent a formal or official view of AQR.
The views expressed reflect the current views as of the date hereof and neither the author nor AQR undertakes to advise you of any changes in the views expressed herein. It should not be assumed that the author or AQR will make investment recommendations in the future that are consistent with the views expressed herein, or use any or all of the techniques or methods of analysis described herein in managing client accounts. AQR and its affiliates may have positions (long or short) or engage in securities transactions that are not consistent with the information and views expressed in this document.
The information contained herein is only as current as of the date indicated and may be superseded by subsequent market events or for other reasons. Charts and graphs provided herein are for illustrative purposes only. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. There can be no assurance that an investment strategy will be successful. Historic market trends are not reliable indicators of actual future market behavior or future performance of any particular investment which may differ materially and should not be relied upon as such. This material should not be viewed as a current or past recommendation or a solicitation of an offer to buy or sell any securities or to adopt any investment strategy. The information in this document may contain projections or other forward-looking statements regarding future events, targets, forecasts or expectations regarding the strategies described herein and is only current as of the date indicated.
There is no assurance that such events or targets will be achieved, and they may be significantly different from that shown here. The information in this document, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Performance of all cited indices is calculated on a total return basis with dividends reinvested.
INVESTMENT IN ANY OF THE STRATEGIES DESCRIBED HEREIN CARRIES SUBSTANTIAL RISK, INCLUDING THE POSSIBLE LOSS OF PRINCIPAL. THERE IS NO GUARANTEE THAT THE INVESTMENT OBJECTIVES OF THE STRATEGIES WILL BE ACHIEVED, AND RETURNS MAY VARY SIGNIFICANTLY OVER TIME. INVESTMENT IN THE STRATEGIES DESCRIBED HEREIN IS NOT SUITABLE FOR ALL INVESTORS. HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH, BUT NOT ALL, ARE DESCRIBED HEREIN. NO REPRESENTATION IS BEING MADE THAT ANY FUND OR ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN HEREIN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY REALIZED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS THAT CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS, ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.
The hypothetical performance results contained herein represent the application of the quantitative models as currently in effect on the date first written above and there can be no assurance that the models will remain the same in the future or that an application of the current models in the future will produce similar results because the relevant market and economic conditions that prevailed during the hypothetical performance period will not necessarily recur. Discounting factors may be applied to reduce suspected anomalies. This backtest’s return, for this period, may vary depending on the date it is run. Hypothetical performance results are presented for illustrative purposes only. In addition, our transaction cost assumptions utilized in backtests, where noted, are based on AQR’s historical realized transaction costs and market data. Certain of the assumptions have been made for modeling purposes and are unlikely to be realized. No representation or warranty is made as to the reasonableness of the assumptions made or that all assumptions used in achieving the returns have been stated or fully considered. Changes in the assumptions may have a material impact on the hypothetical returns presented. Actual advisory fees for products offering this strategy may vary.
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Broad-based securities indices are unmanaged and are not subject to fees and expenses typically associated with managed accounts or investment funds. Investments cannot be made directly in an index.
Russell indices, source: Bloomberg
- The Russell 1000 Growth Index is a composite derived from the Russell 1000 Index that includes large and mid-cap companies located in the United States that also exhibit the growth investment style.
- The Russell 1000 Value Index is a composite derived from the Russell 1000 Index of large and mid-cap companies located in the United States that also exhibit the value investment style.
- The Russell 2000 Value Index is a composite derived from the Russell 2000 Index of small cap companies located in the United States that also exhibit the value investment style.
- The Russell 2000 Growth Index is a composite derived from the Russell 2000 Index of small cap companies located in the United States that also exhibit the growth investment style.
HML series, source: AQR, AQR Data Library:
- Pricing and accounting data are from the union of the CRSP tape and the Compustat/XpressFeed Global database. The universe is all available common stocks in the merged CRSP/XpressFeed data.
- HML: book equity (BE) divided by current total market value of equity (ME). To obtain shareholders’ equity we use Stockholders’ Equity (SEQ) but if not available, we use the sum of Common Equity (CEQ) and Preferred Stocks (PSTK). If both SEQ and CEQ are unavailable, we proxy shareholders’ equity by Total Assets (AT) minus the sum of Total Liability (LT) and Minority Interest (MIB). To obtain book equity (BE), we subtract from shareholders’ equity the preferred stock value (PSTKRV, PSTKL or PSTK depending on availability). We assume that accounting variables are known with a minimum 6-month gap and align book price of the firm at the end of the firm’s fiscal year ending anywhere in calendar year to June of calendar year
- Fama French’s HML: to compute book to market ratios, we scale BE by the ME at fiscal year end following Fama and French (1992, 1993 and 1996).
- HML Devil: to compute book to market ratios, we scale BE by the current ME at the end of each month following Asness and Frazzini (2013).
- Industry neutral: The intra-industry version ranks stocks within industries only so as to take no industry bets. The industry classification is based on SIC (Standard Industrial Classification) codes before 1986 and MSCI GICS (Global Industry Classification Standard) codes after 1986. The long side of each portfolio includes the best (cheapest) 30%, while the short side includes the worst (richest) 30%. The long and short sides are then market-cap weighted.
Hypothetical AQR Long/Short Factor, source: AQR:
- The AQR Long/Short Valuation factor is a U.S valuation theme backtest utilizing the full set of underlying factors that compose the Valuation theme within AQR’s Global Stock Selection strategy to evaluate stocks and create a long-short, market-neutral and industry-neutral equity portfolio based exclusively on these signals within the U.S. region. Within the composite of Value signals are: B/P, E/P, S/P, CF/P, and some other proprietary value measures. The Valuation Theme is designed to capture the tendency for relatively cheap assets to outperform relatively expensive ones. Backtest returns are gross of advisory fees and transaction costs from February 13, 2020 (when data is available). The backtest utilizes a monthly rebalancing schedule and target 7% annual volatility. The investment universe is U.S. large cap. The risk model used is the Barra U.S. Equity Risk Model (USE3L).