Rather surprisingly, the equity strategy framework can provide an estimate of current expected stock market returns. This is accomplished by measuring the recent investor response to each strategy, which, it turns out, captures the deep behavioral currents driving market returns. The resulting information is useful when managing equity market exposure.
Investment strategies were first introduced in this series as an alternative to the Style Grid for forming active equity mutual fund peer groups. Follow-up articles discussed the advantage of diversifying equity portfolios based on fund strategy, how to identify the best funds within each strategy, when stock picking works best, and how fund managers overweight their best-idea stocks. We close the series examining the power of strategies for estimating expected market returns.
Market Factors and the Strategy Market Barometer
As we know, aggregate stock market returns are driven by the collective buy and sell decisions of individual and institutional investors. Many market factors enter into their decisions, and the relative importance of each factor evolves over time. At times, investors place more importance on economy-wide data, stock market activity or specific industry sectors or stocks.
When estimating overall market expected returns, it is important to know the current mix of factors favored by investors. Our research at AthenaInvest has identified 10 equity strategies, introduced in this article, that active equity managers pursue in order to generate superior returns. Each strategy focuses on a specific set of market factors. For example, Competitive Position (CP) fund managers might focus on innovative companies, building an investment process around factors such as strong management and defensible market positions.
A strategy’s most recent return rank relative to other strategies varies over time because investors collectively focus on a changing mix of factors. However, investment managers usually pursue their investment strategies regardless of whether they are in favor with investors. Managers keep doing the same thing while investors change their focus, which provides a stable prism for viewing what is being favored by investors at a given time.
The Strategy Market Barometer (SMB) developed out of our research captures the factors being rewarded at any given time. A high SMB means that market participants favor a high-return factor mix, while a low SMB means participants favor a low-return mix. Consequently, a high SMB implies a high expected market return, and a low SMB a low expected return.
Instead of revealing whether recent market returns have been positive or negative, SMB focuses on relative strategy return ranks. The SMB can be high or low regardless of recent market performance.
SMB is not a traditional measure of market sentiment but instead captures actual investor behavior. Strategy return ranks are the result of collective investment activity, so they reflect what investors do rather than how they feel about market conditions. The SMB is a “put your money where your mouth is” type of measure.
Calculating and Using SMB
Monthly strategy index returns are calculated by averaging the monthly returns for all funds in a given strategy. The 2,000 or so U.S. active equity mutual fund monthly returns used are net of any automatically deducted fees.