Momentum, Diversification and Multi-strategy Funds

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Momentum, Diversification

and Multi-strategy Funds April 29, 2016

The casual analysis of market moves in Q1 2016 does not fully explain the performance of hedge funds over the period. In addition to changes in global macroeconomic conditions and market dynamics over the course of the quarter, hedge fund performance was driven by the impact of momentum and concentration across portfolios and the structure and behavior of multi-strategy funds. The market rotation witnessed in Q1 2016 had its origin in the second half of 2015. Central to what happened was the significant reversal in the performance of the equity momentum factor. Anatomy of the momentum factor A cross-sectional momentum strategy bets that past winners will continue to outperform past losers without regard to underlying fundamental value. The strategy is employed explicitly by long/short quantitative investors and discretionary sector focused portfolio managers that trade within a multi-strategy fund. The typical manager buys the top decile performing stocks in a sector over the past 6 or 12 months and sells short the bottom decile stocks. The portfolio is constructed in such a manner that is market neutral and the strategy is rebalanced over time to minimize style drift. The strategy is also implicitly employed by many equity long/short funds as well as long only funds managed against a market cap weighted benchmark1. This strategy is markedly different and should not be confused with time series momentum (trend following) – the strategy followed by CTAs.

Source: Weiss.

1 Dimitri Vayanos Paul Woolley, “Curse of the Benchmarks”, London School of Economics, Paul Woolley Centre,

Discussion Papers No 747, March 2016

QUARTERLY LETTER Q1 - 2016 KI CAPITAL GMBH

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Momentum is unique as a strategy because its underlying fundamental characteristics evolve, always reflecting the prevailing "working" theme(s). After a period of persistent risk-adjusted gains, the factor has the potential to proxy crowded trades. This is particularly problematic in low breadth environments, as it further reduces the number of independent investment opportunities, and illustrates the increasing scarcity of true alpha2. In such environments, asset managers face significant challenges to generate returns without taking undue, highly correlated risk. As the chart on pg. 4 shows, the momentum factor in the beginning of 2016 reflected defensive themes that had worked well since May 20153. The chart shows the largest net style exposures of a traditional sector neutral, long-term momentum factor constructed at the end of Jan 2016. It is tilted towards lower turnover, lower volatility, and lower financial leverage companies which are relatively more expensive, but offer the potential for profitability and growth. Looking at the detailed performance of momentum over the past year reveals two important properties of the trade; as the chart below illustrates4, much of the factor’s performance in 2015 was driven by the underperformance of laggard stocks, which itself was heavily influenced by macro themes. Furthermore, momentum worked well across all sectors, but the performance was especially strong particularly within the energy and materials sectors. The collapse of commodity prices and oil in particular were the major drivers of the performance.

Analyzing the performance of momentum over long horizons reveals that the return of the strategy is negatively skewed; the strategy is known to experience infrequent but strong bouts of negative returns. This highlights the fact that the cross-sectional momentum trade is negatively convex. As momentum drives the spread between winners and losers wider, it alters the true beta of the long/short portfolio. Shorts that have fallen substantially over a period of time are less likely to fall further relative to longs as the momentum trade gets extended. Longs on the other hand have become fundamentally overpriced and hence have more room to correct in a reversal.

2 Charles Crow IV and James Kelly, “Shrinking Alpha, Momentum, and the Illusion of Diversification”, Weiss Multi-

strategy Advisers, March 2016. https://www.gweiss.com/Insights/Illusion-of-Diversification.aspx 3 Ibid. 4 Ibid.

https://www.gweiss.com/Insights/Illusion-of-Diversification.aspx


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The following Table5 shows all sell-offs of long/short momentum since 1986 where the drawdown was worse than -10%. There have been a total of 19 events over the past 30 years. For each event, the size of the decline, the duration of the sell-off and its intensity (the percentage of decline per month) are shown. Additionally, information on the size, duration and intensity of the rally in the momentum factor prior to the drawdown is provided.

Source: JP Morgan.

Although the sample size is small in order to draw meaningful conclusions, these events have occurred once every 18 months, resulted in an average drawdown of -20.7%, and lasted approximately 7 months. The distribution of these events is clearly non-normal and skewed to the left. Relative to history, the current event is typical in terms of size but the third most intense in history. The unwind of the momentum trade Violent momentum reversals are a manifestation of two events; overshooting and portfolio rebalancing. Significant market moves are driven by a new set of beliefs (valid or not) that become fully priced. There is a differentiation between the holders of the long and short momentum portfolios6; shorts are typically held by "fundamental value" investors who are not willing to sell their positions at any price. They have been holding or even adding to their positions as these stocks became cheaper. As the demand to cover short positions by levered long/short investors increases, while the supply of available stocks to buy is scarce, these stocks become short squeezed. In contrast the long momentum stocks are unattractive to fundamental investors as they are still overvalued by their metrics. Thus these stocks are sold to "other" momentum investors – momentum investors trading to each other. This "asymmetry" exacerbates the deleveraging of momentum portfolios when it occurs.

5 Dubravko Lako-Bujas et.al., “Analysis of Historical Momentum Sell-Offs: Risk of Further Weakness Remains”,

Equity Strategy and Quantitative Research, JP Morgan, March 31, 2016. 6 Thanks to Ray Zemon for the extremely insightful comments regarding this point.


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The recent unwind of the momentum trade started in late January, coinciding with the bottom in oil prices, and a local equity market bottom. The following chart shows the weekly performance of the MSCI World Index, the Societe Generale (SG) CTA Index and a composite of six (equally weighted) large multi-strategy hedge funds. The six funds included in the composite manage approximately $100 billion of assets; with the leverage employed they have exposures of several hundred billion dollars across global equity markets.

Source: KI Capital

In the first four weeks of the year, equity markets sold off significantly with the MSCI World finishing January down approximately -6%. CTAs that were already short equities in the beginning of the month increased their shorts throughout January and performed very well, with the CTA Index finishing the month up 4%. Interestingly multi-strategy hedge funds held very well in terms of performance finishing January only marginally down. In February equity markets resumed their downtrend; by the second week of the month, the MSCI World was down -11.5% for the year. CTAs rallied further as they maintained their maximum net short exposure to equities. The momentum unwind gathered significant pace as fundamentally weak shorts started to rally. Most of these shorts were simply the highest risk stocks. These types of stocks tend to rebound quickly amplifying losses and the short squeeze. Multi-strategy hedge funds lost approximately -3.5% in the first two weeks of the month. Losses triggered the liquidation of large momentum portfolios by multi-strategy/multi-manager funds as individual portfolio managers hit their stop loss triggers and risk managers rushed to reduce overall portfolio leverage. We estimate that approximately $50 billion of stocks – mostly in the US – were sold or bought back by multi-strategy hedge funds over the course of a couple of weeks. This unwind triggered a first wave of repositioning in discretionary equity long/short managers. Their holding of concentrated positions in crowded long and short positions suffered, with popular longs underperforming and popular shorts outperforming. The problem was exacerbated by the fact that most equity long/short managers run portfolios with significant net exposure. After bottoming on February 11th, global equity markets rallied substantially. But equity market performance masks the difficulties faced by multi-strategy hedge funds. The first week of March brought a sharp reversal of momentum in energy stocks and the liquidation of long momentum positions. Previous


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winners – typically high quality low volatility stocks, were sold off simultaneously with the short covering of the fundamentally weak previous losers. The performance of our composite multi-strategy index finished the quarter down -5%, as funds did not participate in the March market rally. Deleveraging continued but at a slower pace into April, hitting European equity long/short portfolios in the third week of the month. Value stocks outperformed growth stocks in Q1 2016, which caused further underperformance for hedge funds. The following chart shows the market neutral hedge fund VIP pair Index (Ticker: GSTHVIPP Index, a proxy for popular hedge fund longs versus shorts) plotted against the market neutral growth vs. value pair spread of the Russell 2000 (Russell 2000 Growth (IWO) vs. Value (IWN)). The Index lost nearly -7% in Q1 2016 and explains a substantial portion of hedge fund losses in the quarter.

Source Bloomberg

The reversal in momentum affected all sectors and was initially focused in the US. For example, within the TMT sector, “old tech” stocks significantly outperformed “new tech”. Software and internet stocks underperformed, while telecoms, traditional media and hardware outperformed. Performance was the complete opposite from the growth/thematic‐driven market of 2015. Crowdedness of the momentum trade Factor investing has become increasingly popular and institutionalized in recent years. Both fundamental portfolio managers and retail investors have invested in new smart beta products that heavily tilt portfolio exposures towards momentum stocks. As these products become more widely used, the crowdedness in the trade increases and would likely exacerbate future unwind/deleveraging events especially in a low liquidity environment impacting all investors that are knowingly or unknowingly in the trade. Equity market neutral quantitative hedge funds also have significant exposure to the momentum factor. These funds did suffer in Q1 2016, but the impact did not resemble anything like the events of August 2007. In 2007, quant funds suffered from crowding across a multitude of factors, equally impacting both their long and short positions. Post August 2007, quant strategies have become far more heterogeneous focusing on different alpha signals, different holding periods and more balanced with respect to liquidity demand/provision. Some funds explicitly bet on fundamental factors and generate alpha from style timing.


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Others explicitly neutralize any portfolio exposure to factors including momentum, and were not influenced by the factor dynamics discussed. Multi-strategy funds exacerbate the extremes of the momentum trade. Many funds exhibit what we call strategy momentum bias. They are inherently long levered momentum as a result of the incentives built in the pay-out contracts of portfolio managers, the hiring and training of particular style managers and of their capital allocation process. Individual manager contracts work on an annual basis. This influences the holding period of “successful” trades. With a quarterly earnings cycle, the holding period of trades is rarely longer than six months and quite possibly significantly shorter. Thus successful PMs are more likely to hold momentum stocks and far less likely to invest in value stocks. They tend to be long companies that are performing better, have relatively cheaper valuations on forward earnings and have better management teams; the companies they are short have the opposite characteristics. Coaching of PMs focuses on making them hold their winners for longer and cutting their losing positions faster. This probably exacerbates trends even further. Finally, the capital allocation process of multi-manager funds is highly pro-cyclical; portfolio managers that are performing well get more capital which gets invested in stocks that are already performing well, perpetuating the momentum trend. In addition, several funds employ so called “center books” – best idea portfolios that supersize the most profitable of the positions of individual portfolio managers. When a reversal in momentum occurs, contractual stop-outs of individual PMs and overall portfolio deleveraging by the management of platforms tend to exacerbate the unwind trade. The space of multi-strategy funds has become more crowded over time. According to the estimates of one multi-strategy fund, in 2010 market neutral levered managers accounted for 7% of the non-ETF trading volume. By 2015, they accounted for 15% of volume (market liquidity fell 20% over the same period). Some managers explain their negative P&L in these unwind periods as “negative alpha”. They claim they tend to run with pretty low factor risk exposures to begin with; but the slightest tilts in their portfolios result in negative alpha during rapid violent unwind periods. We believe that this is an additional risk investors in long/short equity funds and multi-manager funds are exposed to – a tail risk driven by liquidations and deleveraging that might be triggered by events completely unrelated to equity markets. Going forward, it is likely that momentum unwinds will occur more frequently and will be more violent than in recent years. Time series vs. cross sectional momentum It has been argued by a number of market participants that the market action in Q1 2016 was significantly influenced by CTA hedge funds that employ time series momentum strategies. In our opinion it is highly unlikely that CTAs had much to do with the momentum trade unwind and the rotation from growth into value stocks. CTAs typically perform very differently from systematic equity market-neutral strategies. They trade primarily index futures and sector ETFs. Few of them trade time series momentum models of individual stocks. The chart below shows the 10day daily correlation between the SG CTA Index and the MSCI World Index during Q1 2016. CTAs were negatively correlated to the MSCI Index in the beginning of the year. They increased their equity shorts during the initial market sell off in January and remained short until mid-March. Subsequently they reversed their positions and went long equity markets sometime in the second half of March. Trading by CTAs has certainly impacted the behavior of market indices but has had little to no impact to the momentum led deleveraging of sector market neutral portfolios.


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Contact Information KI CAPITAL GmbH Breitenstrasse 66 8832 Wilen bei Wollerau Switzerland Tel: +41 79 848 8480 Email: [email protected]

Source: KI Capital

Kostas Iordanidis KI Capital GmbH

Momentum, Diversification and Multi-strategy Funds

Economy & Finance

Transcript of Momentum, Diversification and Multi-strategy Funds