In a previous post, we had analyzed the underwhelming performance of neutral strategies until early Q2. Extreme stock volatility, heavy systematic trading volumes, the dominance of speculative drivers (the pandemic, multiple stimulus, the oil price war) and their delayed showing in macro and corporate statistics all contributed to impair fundamental stock-picking approaches. A fast stock re-correlation, insufficient contribution from shorts and major factor/sector rotations were additional challenges. We had also expected that with normalizing trading conditions, the environment would eventually become more fundamentally-driven, in support for neutral strategies. We might have gotten there.
There have been four major factor rotations so far this year. The first one started with the market crash, when momentum broke through. The second one followed at the end of March, as markets troughed, leading to a rally in cyclical stocks and small caps. The third one gained traction by mid-May, in market euphoria, with a surge in value vs. growth out of momentum. The last one to date occurred during the June market correction, largely reversing the third rotation.
Factor volatility peaked in May, reflecting the declining amplitude of rotations. Meanwhile L/S Neutral strategies have deeply reshuffled their allocations, out of value, quality and defensive stocks, into smaller caps and growth factors. These changes, along with a broadening sector leadership, a deeper focus on stock fundamentals (especially in the small- and mid-cap segments), and improving shorting conditions, all helped generate positive alpha. A wider differentiation across neutral managers is also a good sign, consistent with the ongoing normalization of stock correlation and dispersion.
Another major value vs. growth catch-up, which could hurt neutral strategies, is unlikely at this stage in our view. Value stocks usually benefit from ample liquidity and an economic recovery. Their valuation discount to growth stocks also stands at record. Yet, the macro inflection is not decisive enough and significant wildcards are holding investors back. Moreover, the value/growth P/E discount is not at odds with their relative fundamentals. A more favorable backdrop for heavy weighted banks and oil prices stabilization would be a prerequisite (see the deep changes in factor constituents since last year p2). All in all, conditions may not be gathered yet for a sustainable rotation towards value. The environment is improving for Neutral strategies, but the fast changing trading conditions keep us in wait-and-see – for now.