During a year in which indexing and other traditional investment strategies faltered, quantitative investing offered a bright spot.
The challenges this year were clear, specifically in: equity markets, with the S&P 500 down about 19% for the year to date; government bonds, with the World Government Bond Index down roughly 17% for the same period; and credit markets, with the Bloomberg Global Aggregate Credit Total Return Index down about 15%.
By contrast, quantitative strategies (as measured by the SG Alternative Risk Premia Index) posted a healthy positive total return of 3.9%, providing both diversification and capital appreciation in a difficult market environment.
Quantitative (or quant) investing uses algorithms to analyze massive amounts of data (such as valuations, quality, liquidity, yields and the speed of price changes) and then systematically makes trades based on this analysis. By definition, this means that trades are grounded in historical data. How, then, will this approach fare in a potentially volatile market with few historical precedents in 2023?
In our view, quant’s strong outperformance in 2022 resulted from a diverse set of catalysts:
- Monetary policy tightening by global central banks led to substantial and durable macro trends that inform quant investors’ “trend-following” strategies.
- With interest rates at different levels across the globe, “carry” strategies allow quant investors to capture the spreads between low and high rates.
- Equity value investing re-emerged as higher rates forced investors to focus more closely on fundamental valuations, increasing the efficiency of the “value” factor.
- Disruptions in valuations related to technological advances surrendered some of their outperformance.
We expect that in the coming year, markets will continue to be driven by macro themes. In 2023, Morgan Stanley anticipates a transition from an environment with generally rising policy rates to one in which inflationary pressure recedes, rate increases end and global growth slows, with GDP growth in developed markets bottoming at 0.2% (annualized) in the third quarter of 2023. Consequently, we expect rates curves to steepen, driving returns for bonds and other fixed income investments, and U.S. equity markets to sell off in the first quarter, reaching levels as low as 3,000 to 3,300 for the S&P 500 before ending the year about flat at 3,900.
From a quant perspective, these significant market swings tend to favor short-to-medium-term trend-following strategies. As the differences in central bank policies across the globe persist, “carry” returns could be attractive. Indeed, being long on bonds in regions with high rates may benefit investors as their holdings appreciate when rates eventually normalize. Finally, defensive value investing tends to be well-placed to deliver returns, offsetting the higher cost of capital.
As long as the environment continues to be favorable for value investing, with market volatility remaining high, investors should concentrate on undervalued stocks of high quality—crossing value filters with quality filters, in quant speak. Value-investing benefits extend to fixed-income value strategies as well.
While we anticipate these strategies should be favorable for 2023, they must be executed carefully. Quant investing requires a balanced portfolio construction that diversifies across different types of quantitative strategies to reap the benefits of this data-driven approach.