Preparing for another unwind
So far in 2016, many of our investors, particularly amongst the hedge fund community, have expressed that 2016 has been a difficult year to produce consistent alpha. We believe the elevated volatility of factor returns contributed to the underperformance. We noted several times already in 2016 that volatility of our factors has elevated. That said, we have observed recently that elevated factor volatility appears to be on the decline. Exhibit 1 shows the average rolling 3-month daily volatility of value factors (average of Next-12M P/E, Actual P/E, Actual P/B, FY1 Price/CF, and FY1 Dividend yield return volatility), and price-return momentum factors (3M, 6M and 12M). The volatility of value factor has hit its highest level this month (Sept 2016) since 2011.
In March 2011, the volatility of factor returns jumped due to the Tohoku earthquake. The volatility of momentum factors are at their highest since 2010. The volatility of momentum factors tend to high by nature, but the recent rise has been significant compared to the historical average of 0.5% (2012 to 2014) vs 1.1% in September 2016. With that effect, our simulated Japanese equity long/short strategy also
had one of the worst monthly performances in August (-2.9% mom, vs +0.7% on average) shown in exhibit 2. We also observed that the rising volatility since 2H 2015 coincided with significant net out flow of foreign investors from Japan. Exhibit 3 shows weekly and cumulative net purchases/sales of foreign investors in the Japanese equity market. From August to October 2015, cumulative net selling by foreign investors reached 4tn JPY. Similarly, from January to March 2016, the cumulative net selling amount by foreign investors totaled 5tn JPY. Since then, foreign investor flow has been relatively low.
However we observed a significant rise in the factor volatility again in July and August. This could also be flow related, not directly in and out of Japanese equity, but flow out from a specific strategy. Accordingly to eVestment’s July 2016 Hedge Fund Asset Flows Report, it is estimated that US$25.2billion was removed from hedge funds in July, and the net negative flow of US55.9 billion 2016 YTD. We believe flow continues to be an important factor in 2016, and believe we could see another period of high factor volatility related to unwinding of strategies. We therefore update our simulated Japanese equity long/short hedge fund portfolio4 in exhibits 5-8, to better understand where potential crowding could be at stock the level. We also recommend monitoring factor exposure closely from a portfolio risk management perspective, and not having exposure to certain factors such as value and momentum for too long. As such, we think the recent decline in the factor volatility could be the calm before a potential storm.
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