The Mega-Cap Conundrum

Image by Arek Socha from Pixabay

By EDWARD J. RAKHAM, PH.D./Los Angeles Capital

2019 was an unusually challenging year for quantitative equity strategies with a large proportion of quantitative strategies underperforming their stated benchmark on a rolling one year basis. There has, therefore, been a great deal of interest in understanding the shortcomings of quantitative portfolios over the same calendar year.

The struggles faced by quants in 2019 were related not just to the efficacy of quantitative signals but also to the ability of systematic strategies to access these signals over that 12-month period – an issue exacerbated by the outperformance of large cap stocks over smaller names over the course of the year.

To further understand the difficulties faced by quants in 2019 it is informative to consider the returns to common quantitative strategies over recent years. The compounded active performance of five simulated portfolios from the end of 2003 to the end of 2019 is given in Figure 1. The portfolios have been constructed using the assets within the developed world opportunity set to have a fixed ex-ante tracking error of 1% relative to a standard world index and, subject to constraints on risk exposures as well as the requirement to be long only and fully invested, maximized exposure to one of the following investment signals: value, momentum, quality, residual reversal and earnings revision. The signals shown represent common quantitative investment factors and the portfolios can be thought of as investable applications that maintain exposure to the listed investment factors at all times.

Figure 1

Click chart to enlarge.

What is immediately clear from Figure 1 is that a quantitative manager implementing one or multiple of these factor portfolios would have added value over the last 15 years. What is also clear, however, is that 2019 saw a downturn in all but one of five of the common quant strategies shown in the figure. Such consistent under performance across almost all of the strategies is unusual. Moreover, at first glance, the results of Figure 1 are somewhat unintuitive. Certainly there were many high quality companies with durable cash flows that performed well in 2019. Residual reversal and earnings revisions factors consistently have proven powerful signals in many different market environments and many of the “winners” in 2019 continued to win throughout the year suggesting that momentum based strategies should also have fared well. Indeed, only the value portfolio’s underperformance in 2019 is in line with expectation as it continues the trend of negative returns to such strategies that have been observed over the last five years.

To further understand the challenges faced by quants and to rationalize investment intuition with Figure 1, it is helpful to consider the performance of the largest names versus the smallest names within the developed world opportunity set over 2019.

Overall, the compounded payoff to the size factor – the return associated with characteristic of being large capitalization – is negative over the last 15 years, consistent with the idea that there is a premium to holding small cap names over larger sized stocks. Performance from the end of 2017 to the end of 2019, however, has been reversed with the largest names in the world developed index outperforming their smaller cap counterparts over the last two years.

Interestingly, the preference for large capitalization names over mid or small capitalization names was even more pronounced in 2019 conditional on those stocks also being, for example, of high momentum or high quality. That is, high quality stocks did well in 2019 if those stocks were also mega caps; high momentum stocks added value if those stocks were also amongst the largest names in the index. Indeed, this was the case for almost all of the factors in Figure 1 throughout last year.

The observation that signal efficacy is concentrated in the largest names for most of the systematic investment signals is of particular relevance to the question of quant performance.

Being overweight the largest names within the global benchmark requires managers to build portfolios with concentrated positions in a handful of large cap names. Many quantitative investment processes tend to result in long only diversified portfolios that hold large numbers of names so as to exploit breadth. Quant portfolios are, as a result, frequently underweight the largest names in the index irrespective of investment style.

Given that quant portfolios tend to access the smaller end of the capitalization spectrum, the performance of the investable quant portfolios of Figure 1 can now be understood. The stark underperformance of investment strategies constructed around these signals was as much related to the portfolio’s ability to access the mega caps within the opportunity set as it was to the performance of the signals themselves. That is, for a given quantitative investment signal in 2019, it was almost always necessary to buy exposure to these factors amongst the largest names in the opportunity set while simultaneously avoiding the smaller end of the market cap spectrum – an allocation that simply does not come naturally to most quantitative portfolios.

Given the market environment of 2019, and the consistent performance of the largest names within the opportunity set, it is tempting to conclude that quant managers should adjust their investment processes to account for continued mega cap performance. While lessons must be learned from the events of 2019 there is also risk in assuming that market environments and factor behavior continues indefinitely. Investor preferences for particular factors and assets tends to be cyclical and while large cap growth assets may continue to perform well in the near future, a change in economic fortunes could result in a change in their outlook.

In the short term, however, challenges to performance may continue to plague quant investment processes if factor efficacy remains focused within the largest end of the market. Nevertheless such an environment does not, on an ongoing basis, preclude the existence of alternative investment ideas within the broad opportunity set that are unrelated to size. Systematic managers who can find such ideas and, importantly, express those ideas efficiently within an investment portfolio may still be able to overcome the headwinds of mega cap outperformance.

Los Angeles Capital is an Associate Member of TEXPERS.The views expressed in this article are those of the author and not necessarily Los Angeles Capital nor TEXPERS.

About the Author

Ed Rackham, Ph.D., is Co-director of Research at Los Angeles Capital and is responsible for overseeing all functions of the Research department which includes: model development, risk management and factor research. Alongside these broad responsibilities, Rackham specializes in the development of Investment Risk Management tools and he and the Risk Management group focus on the research and development of portfolio construction techniques that are designed to forecast and control the investment risk of the firm’s portfolios. In addition, Rackham and the Risk Management group look at ways to embed the firm’s stock selection views into investment portfolios in a cost-controlled fashion while simultaneously controlling for forecast uncertainty in both portfolio’s expected performance and the portfolio’s forward-looking risk. Prior to joining Los Angeles Capital, he spent six years at Wilshire Associates researching and developing risk and portfolio analytics tools, most recently as the Head of Research and Development of their Equity Analytics group. Previously, Rackham was an instructor in mathematics and physical chemistry at the University of Oxford, where he also earned his doctorate.