Ominous signs are multiplying for the hottest quantitative strategy since the financial crisis as market leaders wobble.
Dubbed momentum investing -- betting on stocks that have gained the most over the past year -- everyone from passive investors to hedge funds have flocked to the trade in recent years, as one of the last ways to beat benchmarks amid relentless rallies.
But as technology stocks struggled to reassert their market-leadership role this week on the heels of Facebook Inc.’s data controversy, strategists are issuing a warning on the crowded trade. Out of the ten U.S. factors tracked by Bloomberg, momentum fell the most Thursday, continuing its biggest two-day slump since Feb. 8.
A new class of investors may have become oblivious to the risks thanks to the boom in tech shares, which have posted the strongest returns of any industry over the past decade and turbocharged momentum strategies in the process.
Over the past year, chipmakers Micron Technology Inc. and Nvidia Corp. alone accounted for more than a tenth of gains in the Bloomberg pure U.S. momentum index.
While contagion from Facebook’s woes was largely limited, allowing the strategy to trade in the green earlier in the week, Jason Williams, a portfolio manager at Lazard Asset Management Ltd., is worried. Too many expensive stocks -- many of which are acutely sensitive to overall market sentiment -- have slipped into the momentum basket, increasing the likelihood of a large drawdown once market leadership finally rotates, he said.
“Given the amount of assets that are in strategies that you can sell at the drop of a hat, it can easily create a repeat of what we’ve just seen in January and February,” Williams said in an interview. “I could imagine a situation where momentum has a few more down days like we saw a couple of days ago and it actually gets worse, and it starts to turn into more of a rotation.”
It’s difficult to put a number on the amount of money focused on the trade but the boom in exchange-trade funds illustrates the trend. Though just a small fraction of the universe, U.S. ETF assets tied to momentum have doubled in less than a year to more than $12 billion, data compiled by Bloomberg show.
Add the birth of smart-beta ETFs along with cheap data, and a large number of investors have adopted the strategy with ease during the nine-year bull market as momentum posted the best returns across the quantitative kingdom.
That all signals a looming risk. Whether it’s fickle sentiment, complacency or unrealistic expectations, allocations may not prove sticky during a prolonged bout of market stress, said Williams. It’s especially dangerous since momentum tends to crash harder than most equity groups.