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The Quant Cycle
Abstract
Traditional business cycle indicators do not capture much of the large cyclical variation in factor returns. Major turning points of factors seem to be caused by abrupt changes in investor sentiment instead. The author infers a quant cycle directly from factor returns, which consists of a normal stage that is interrupted by occasional drawdowns of the value factor and subsequent reversals. Value factor drawdowns can occur in bullish environments due to growth rallies and in bearish environments due to crashes of value stocks. For the reversals, the author also distinguishes between bullish and bearish subvariants. Empirically, he shows that his simple three-stage model captures a considerable amount of time variation in factor returns. The author concludes that investors should focus on better understanding the quant cycle as implied by factors themselves, rather than adhering to traditional frameworks that, at best, have a weak relation with actual factor returns.
This article examines the performance of equity factor portfolios during the quant crisis of 2018-2020. The author finds that there was basically only one way to outperform during this period, namely by investing in the largest and most expensive growth stocks. Other factors were only effective to the extent that they provided implicit exposure to the same large growth stocks. Smaller stock portfolios underperformed across the board. Thus, there were numerous ways to fail during the 2018-2020 period but, essentially, only one way to succeed. Comparing the quant crisis with previous major drawdowns of the value factor, the author finds that these other periods are better characterized as momentum factor rallies with collateral damage for the value factor. Moreover, smaller stocks typically still offered possibilities for outperformance. The author concludes that the 2018-2020 quant crisis posed an exceptional challenge to quantitative managers due to a rare combination of circumstances.