Is Factor Investing Driving the Market ?

Bloomberg had a fascinating article pointing to the influence of factor investing in the market.

The popular narrative is that stock pickers are selling tech after the massive runup this year and are piling into companies set to benefit from U.S. tax cuts. But observers such as Andrew Lapthorne of Societe Generale SA don’t buy it. They look at the contours of the selloff over the past few days and have a different take: A few heavy hitters are dumping factor positions that incidentally hurt chipmakers and software companies and once they’re done, the rally will resume.

Two factors stood out last week. First, the plunge in the momentum trade (betting on past winners to continue winning), and second the gains in value (seeking out underpriced stocks) to near-record proportions. Because the moves were severe in U.S. stocks and occurred across sectors, macro forces aren’t causing a rotation from technology to financials, strategists reason. Rather, computer-driven funds liquidated or readjusted factor exposures, they say...

“The ‘momentum unwind’ effect is observable even within sectors,” Chintawongvanich wrote in a Tuesday note. “We find that they tend not to portend much for the market; once the unwind has run its course, typically the ‘long momentum’ stocks resume rallying.”

But more than momentum, the culprit here was probably value, according to Lapthorne, who notes that last week, the strategy betting on the cheapest stocks had its biggest daily rebound since March 2009.

What is fascinating here is that large numbers of computer driven traders are employing factor trades...and doing it on a long/short basis in the case of momentum going long stocks with positive momentum and short stocks with negative momentum. Such a trading strategy would need to be quickly unwound if it reversed. Given the underperformance of value stocks it is likely that many value stocks were on the short side.

Once short term players with leverage all follow a similar strategy the moves can be abrupt and not just driven by fundamentals.

With regards to factor investing it seems that the short term traders took the insight that factors influence stock movement and turned it into a strategy for leveraged trading,

In other words they are turning what should be a long term asset allocation strategy and using it for tactical trading.

Long term investors should do quite the opposite of what the traders do. They should have a portfolio balanced among factors holding both value and momentum since the two are generally not correlated. Therefore the combination of the two helps diversify a portfolio.

In fact the moves of short term traders is "noise" for long term investors best to be ignored or seen as opportunities to implement long term strategies.

Three month chart momentum (mtum)  etf vs large value (VTV)

VTV (brown) MTUM (black)