doubling up on momentum

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Chapter I Doubl ing up on momentum. This is not 2009 (or 2000) 4
The sharp style moves seen in Europe, the US and globally since 21 March have seen Momentum sell off by 7%, 5% and
6% respectively to the close of Monday 14 April. These are very large moves. With Momentum having now given up all of
its gains since we went long the style in early January, our call to be long Momentum in Europe and globally is losing
money.
As a result of the recent moves, the style is now cheaper than it has ever been before. In Europe, the high-momentum
stocks are now trading at a 27% discount to the low-momentum stocks – this is unprecedented. Globally, the ‘winner’
stocks are also trading at historical lows. Previous sustained Momentum sell-offs have always happened from much
higher multiples.
We consider several explanations that we have heard proposed for the recent moves, including the Nasdaq sell-off,
various macro triggers, an EM-driven rotation and fund delevering. Although we think these have some merit, none
seems to offer a compelling or complete explanation, nor a reason for these style trends to continue.
We see recent underperformance of Momentum as a buying opportunity both in Europe and globally. We are doubling up
our position in Momentum in our Global Recommended Quant Portfolio.
Al la Harmswo rth
Chapter II Of bonds and bubbles – value outperforms in rates, as in equities 14
Value investing is nothing new. Especially in equities, value investing is among the oldest and most well-known strategies.
As early as 1934, Benjamin Graham and David Dodd spelt out the principles of value investing in their text 'Security
Analysis'. Academics such as Eugene Fama and Kenneth French have also studied value formally. For example, Fama &
French (1992) used value as part of their three-factor model of stock returns. Legendary investors like Warren Buffett and
Seth Klarman famously use the principles of value to guide their investment decisions.
In this article, we focus on value in interest rates. W e find that using techniques fundamentally similar to those used in
equities can help rates investors identify value across both curves and currencies. We discuss the following points:
• Value exists in both equities and interest rates.
• Carry in interest rates is analogous to earnings yield (E/P) in equities. Just as stocks with high earnings yield outperform
those with low earning yield, curve points with high carry outperform those with low carry.
• Comparing earnings yield both relative to its own history (time-series) and across stocks (cross-sectional) is important to
place current valuations in context. Similarly, comparing carry on both time-series and cross-sectional basis is key.
• A long/short value strategy in rates outperforms a long-only benchmark. Being free to trade the best points of value
across curves and currencies, without constraining the strategy to hold pre-specified pairs, can help make the strategy
robust.
• Bubbles develop gradually, be it in equities or rates. Equities and rates do not sell off when they are cheap – crashes
occur in the context of stretched valuations. Value-signals can help track a build-up in overvaluation and identify when sell-
offs in rates are more likely.
• A long-only version of the value strategy outperforms a long-only benchmark on a duration-matched basis. By going long
the cheapest curve points across countries, the strategy beats a static benchmark that holds the entire market.
• A short-only version of the value strategy can help hedge rising rates. It can also be cheaper than being the short the
entire market as it identifies the most expensive points to be short rather than shorting all points.
• Value can outperform when Momentum suffers. Momentum tends to underperform when rates are close to zero and
markets range-bound. In such trendless conditions, value or mean-reversion trades tend to outperform.
Anthony Morr is
Chapter I II Concentrated posit ion unwinding on 24 March 28
From 24 March 2014 through the morning’s trading session on 25 March, actively managed Japanese equity funds faced
a relatively strong headwind, especially in large cap universes. Strategies based mainly on analyst earnings forecast-
related factors and stocks with high active-fund ownership ratios produced negative returns of less than -3% over this
period. It is highly probable that, for some reason, there was a concentrated spate of selling for position unwinding
purposes by active funds on those two days. The sell-off appears to have come to an end before the start of the afternoon
trading session on 25 March, but we think there is still a need for caution.
We all remember the 'quant headwind' in August 2007, when selling pressure was similarly concentrated on certain
investment styles, such as E/P-based factors, and the performance of a number of factors plummeted at the same time in
multiple markets around the world. This time around, however, we think the sell-off was not because of the unwinding of
positions by global funds but the selling by Japanese active pension funds.
While it is difficul t to pinpoint the reasons for selling by Japanese active pension funds, we think investors need to be
aware of the possibility of a similar thing happening again. One reason for this view is that the dissolution of employee
pension funds (EPFs) is about to take off on a large scale. Whether or not what happened on 24–25 March was linked to
the return to the state of the substitutional portions of EPFs, the risk remains that a similar thing could happen again. A
positive way of looking at what happened on 24–25 March would be to say that it has served as 'disaster training' in
preparation for the risk of future unwinding of pension fund positions.
Based on this view, we would like to stress the importance of avoiding stocks that are the object of herding by active
funds. For example, if we assume that there is a substantial unwinding risk for stocks in which only domestic pension
funds are substantially overweight, then avoiding these stocks is likely to be an effective strategy. This kind of strategy
would have performed well from mid-January 2014, and would have generated positive returns without suffering a
negative impact on 24 March 2014.
Aki hi ro Murakami

3
Foreword We usually like to take a longer-term view in these notes, but occasionally events take
over. On Monday 14 April, Momentum suffered a 2.6% intra-day fall in Europe, a 2.6
standard deviation move. 1
Several aspects of this move are remarkable: both sector-neutral and non-sector-neutral
Momentum suffered falls of a similar size. It has occurred without a clear index-level
impact (the market has been both up and down over the course of the three-week move,
and even over the course of the day on 14 April). It also has happened without an
obvious ‘fundamental’ catalyst.
Conversations with clients have been focused on this issue for several weeks now. The
Momentum sell-off is causing particular pain in levered market-neutral strategies, and
this seems to be especially the case in those with shorter holding periods where
momentum is used particularly often. The impact on long-only investors has been more
muted.
Although a move of the size of 14 April probably has to be caused by fund de-levering,
the ultimate cause is hard to pin down and, we suspect, may be the result of several
forces. What we do know is that it leaves Momentum more cheaply valued than it was
before. We upgraded our view on Momentum globally on 7 January 2014. As a result,
we have to be humble here as we have lost money for three weeks. However, with
Momentum now trading cheaper than it ever has done before in 25 years in Europe, we
think this presents an opportunity. This is not 2009 or 2000, periods when Momentum
sold off in a sustained way because on both those occasions the factor was (very)
expensive. As a result, we double our position in Momentum. The first section of this
note explores this recent fall and explains the upgrade.
At the same time as the Momentum sell-off in the US and Europe there has been a large
factor move in Japan that has also caused severe dislocation to some funds – again both
quant and non-quant. Another section of this note discusses this move in detail. We think
that ultimately it is unrelated to the move in the other regions, and is probably led by the
unwinding of domestic pension funds, but that means that such a move could potentially
occur again.
This month we also have a piece that takes a longer term view of value in a cross-asset
sense by applying it to rates as well as equities at the index level. We show how a long-
short value strategy within rates outperforms a long-only benchmark; we also show a
long-only version of the strategy that also outperforms on a duration-matched basis.
Inigo Fraser Jenkins

4
Doubling up on momentum; this is not 2009 (or 2000) • The sharp style moves seen in Europe, the US and globally since 21 March have seen
Momentum sell off by 7%, 5% and 6% respectively to the close of Monday 14 April.
These are very large moves. With Momentum having now given up all of its gains since
we went long the style in early January, our call to be long Momentum in Europe and
globally is losing money.
• As a result of the recent moves, the style is now cheaper than it has ever been before.
In Europe, the high-momentum stocks are now trading at a 27% discount to the low-
momentum stocks – this is unprecedented. Globally, the ‘winner’ stocks are also
trading at historical lows. Previous sustained Momentum sell-offs have always
happened from much higher multiples.
• We consider several explanations that we have heard proposed for the recent moves,
including the Nasdaq sell-off, various macro triggers, an EM-driven rotation and fund
delevering. Although we think these have some merit, none seems to offer a compelling
or complete explanation, nor a reason for these style trends to continue.
• We see recent underperformance of Momentum as a buying opportunity both in Europe
and globally. We are doubling up our position in Momentum in our Global
Recommended Quant Portfolio.
The mysterious rotation
The factor moves we have seen over the past three weeks in Europe and the US have
been sharp and, to most people we have spoken with, very unexpected. The rotation – in
particular, the sell-off of Momentum in both regions and the rally in Value, which was
particularly strong in the US – was especially surprising because it seemed to have no
obvious catalyst, and initially unfolded against the background of broadly flat markets
and reasonably unexciting (in either direction) corporate and macro newsflow.
Fig. 1: US Momentum and Value
Source: Nomura Quantitative research 2
Fig. 2: European Momentum and Value

Source: Nomura Quantitative research
The moves started in early March, but intensified towards the end of the month, with
Momentum falling by 100bp and 190bp, respectively, in Europe and the US in the last
week of March alone. Strikingly, the ‘winners’ were also sold off within sectors, ie, on a
sector-neutral as well as a market-wide basis (Figs. 1 - 3). Value performed well at the
same time, although it outperformed significantly more in the US than it did in Europe,
delivering a 2.9% return compared with Europe’s more modest 60bp.
2 . Long-short returns of factors by region. Value is defined as an equally weighted
combination of price/book, trailing dividend yield and 12-month forward P/E. Momentum
is defined as an equally weighted combination of a simple 12-month price momentum
and the percentage change over the past two quarters in average consensus 12-month
forward earnings estimates. The baskets are rebalanced quarterly.
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Alla Harmsworth – NIplc

Fig. 4: European Factor perfo rmance
Source: Nomura Quantitative research. Risk is defined as an equally weighted combination of standard deviation of returns, earnings expectations and beta. Growth is defined as an equally weighted combination of Internal Growth, five-year consensus expected growth rate and three year forward growth rate. Quality is defined as an equally weighted combination of ROE, credit rating, tax/pre-tax income, EBITDA margin and change in the number of shares. The baskets are rebalanced quarterly.
Fig. 5: Global Factor performance
The broad indices, confusingly, were flat at the same time, and there was also a lack of a
clear pattern in terms of the performance of other factors or sectors that would have
helped interpret the moves in Value and Momentum. The Value rally would normally
signify a pro-cyclical bounce – yet in the US, where Value rallied the most, Risk
underperformed slightly at the same time, while Quality outperformed. At the sector level,
the better performers at the time were a mixture of Financials, some non-commodity
cyclicals, Energy and classic defensives, such as Telecoms and Staples. In Europe,
performance of other factors and of sectors was similarly mixed.
After the initial bout of sharp declines, Momentum had something of a rebound the
following week, only to sell off again, and more sharply, the week after. Monday April 14
saw further large moves with Momentum falling by 3% and 1% intra-day in Europe and
globally. One difference between the two episodes of underperformance was that the
second time around, markets were down too, both in Europe and the US. At the sector
level, things also felt more obviously defensive than in late March. Staples and Utilities
rallied along with Energy, while most cyclicals did badly. Importantly, Financials also
underperformed last week, in contrast with what happened in March. The broader
decline in sentiment in the past week was reflected in our Composite Sentiment
Indicator, which has just moved to levels indicating weak sentiment, having fallen to the
lowest it has been since November 2012. That said, on Monday 14 April – the day that
saw some of the sharpest intra-day moves since the rotation started three weeks ago –
markets were broadly flat overall.
Unsurprisingly, a number of fund managers have told us that they suffered losses in
recent weeks. The underperformance has been most painful for some levered market-
neutral funds – both fundamental and quant. Even for those who did not lose money,
these recent moves have been a major focus and a source of concern, and
understandably so. A Momentum sell-off is always a worrying event because (and this is
one reason why so many investors are so uncomfortable with it) when Momentum
investing goes wrong, it can go very wrong. An (admittedly extreme) example is 2009,
when the strategy lost all the gains it had made in the previous decade within months.
We explain below, however, that we think there is a crucial difference between the factor
now and in the periods preceding any meaningful draw-downs in the factor in the past 25
years – that difference is valuations. With Momentum currently trading at literally
unprecedented lows, we do not expect a sustained sell-off in high-momentum names –
historically, these have always happened when these names were very significantly
more expensive than they are now.
A number of explanations for the recent factor moves have been put forward. In the rest
of this note we discuss the ones we have heard most often. We think that, although
some of them may have some merit, none offer a convincing enough explanation for the
moves, nor do they give a reason to expect these style trends to continue. We see
recent underperformance of Momentum as a buying opportunity on a three-month view
and beyond, and are doubling up our position, both in Europe and globally.
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Composite Risk Size

A Macro catalyst?
The first obvious place to look for an explanation of a sharp factor rotation like this is a
macro-related catalyst. It is possible that some of the move in early March was indeed
caused by changes in macroeconomic sentiment. Figs. 6 and 7 show that the initial sell-
off in Momentum and the outperformance of Value in the US in March was accompanied
by a rising Economic Surprise Indicator, which has recently tended to be positively
correlated with Value and negatively with Momentum. In Europe, there has been
something of a positive relationship between macro sentiment – at least on this measure
– and the performance of Momentum, and the late-March Momentum underperformance
did indeed coincide with a decline in the surprise index there (Fig 8). (The relationship of
the indicator with Value in Europe is less clear (Fig. 9).)
Fig. 6: US Macro and Momentum perfo rmance
It is conceivable that in the US, the improving macroeconomic sentiment through March
was at least partially responsible for the boost to value stocks as they are more pro-
cyclical (through their greater exposure to Financials) while hurting Momentum through
its greater exposure to more ‘stable growth’ sectors, which tend to do best when the
economy peaks or starts to slow. In Europe, if Momentum suffered from a decline in
macroeconomic sentiment that is suggested by the Economic Surprise series, it would
have been through its ‘short’ side, ie, its large underweight in the defensive sectors,
which did well at the time (see Fig. 10 for the sector composition of Momentum in the
US and Europe). However, as we mentioned above, other sector moves were far too
mixed for us to believe that these style moves were entirely macro-driven. Besides, this
measure of macro sentiment does not help explain the second phase of the Momentum
sell-off, with the surprise indicators in both regions either moving in the ‘wrong’ direction
or by insufficient amounts at the time.
More generally, recent macroeconomic data and newsflow seem to have been broadly
benign or neutral in both regions. The ECB indicated on Thursday 3 April that the
possibility of QE was unlikely to have a large impact at the point of the announcement,
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7
given that QE would be unlikely to happen unless and until European macro data get a
lot worse. In the US, some positive labour market data have been indicating that the
impact of bad weather on the economy is largely over – but again this hardly seems
sufficient to have triggered the sudden and large-scale moves that have taken place.
One specific macro ‘event’ that we have often heard mentioned in connection with the
initial moves of late March is Janet Yellen’s speech on 18 March. Again, we do not think
this holds a clue to what unfolded. The Value rally and the Momentum sell-off did not
gather pace until about three days after the ‘hawkish’ speech was delivered. Further, her
second, ‘doveish’ correcting speech did not prevent the second phase of
underperformance – so the first one seems to have been an unlikely trigger to begin
with.
In conclusion, there seems to have been no obvious macro-related cause for the style
moves of the past three weeks. This is not to say that the moves were entirely unrelated
to the macroeconomic environment – only that no particular aspect of it seems to offer
an explanation for their sharpness and suddenness, or gives a reason to expect these
moves to persist.
The US ‘new economy’ profit taking
The sell-off in the US Tech and Biotech stocks – which have corrected sharply in the
past few weeks – is another commonly cited reason for the Momentum correction that
we have been hearing. Again, this may have been a contributing factor – both directly, in
so far as the Momentum baskets are exposed to the Tech/Biotech names that have sold
off, and indirectly through potentially causing a ripple of profit-taking behaviour in other
sectors and stocks that make up the style.
Momentum has a positive weight in Technology both in Europe and the US – although
currently considerably more so in the US (Fig. 10). Furthermore, within Tech, the style is
net long Internet stocks (with 1.5% exposure in the US and 1% in Europe), which had
seen a substantial run in performance prior to March (Figs. 11 and 12). Momentum is
also exposed to Biotech, with a net 3.8% weight in the subsector in the US and a 3%
weight in Europe. This is hardly surprising considering the dizzying performance the
sector has delivered over the past couple of years.
Both Biotech and Internet stocks have declined sharply in the US in recent weeks, down
10% and 8%, respectively, during March; both also fell further in the first week of April.
The timing of the brunt of the sell-off in March did loosely (though not precisely) coincide
with the timing of the Momentum sell-off.
Fig. 10: Composite Momentum – net sector exposure, % (long - short)
Europe US

However, in Europe, the sell-off in the (tiny in size) Biotech sector was much more
modest in magnitude, with the sector falling by 3% during March compared with 10% in
the US; furthermore, the two or three stocks in Europe in the Internet subsector actually
rose during March, with some of the bigger gains occurring just as Momentum was
suffering towards the end of the month. So this particular explanation does not seem to
offer much insight into what has gone on in Europe.
Even in the US, the overall exposure of the Momentum basket to Biotech and parts of
Tech that may still be vulnerable to further correction seems far too small for the
performance of the overall style to be dominated by these stocks.
The Tech/Biotech unwinding may have also been having an indirect effect on Momentum
by encouraging a bout of profit-taking to take place in other sectors, both in the US and
in Europe. Almost tautologically, given that we are talking about a Momentum correction,
there has been something of a tendency to sell whatever has gone up the most across
sectors, as shown in Fig. 14, which plots the European sector relative performance since
21 March, when the moves started, against their performance since the beginning of last
year. Wider profit-taking behaviour is also evidenced by the fact that, as we mentioned
above, the style has corrected on a sector-neutral as well as a market-wide basis – that
is, ‘winners’ have also been sold off within each broad sector.
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Fig. 14: European sector relative perfo rmance since Dec 2012 and 21 March 2014, %
Will this continue to affect the style? For one thing, the profit-taking behaviour is likely to
have been exacerbated by concern regarding the forthcoming earnings season, which in
the US has been precipitated by fairly gloomy company guidance and a sizeable
downward adjustment in earnings expectations for US stocks in recent weeks. We think
that, as the earning season gets underway, this effect will diminish in importance, with
any potential negative surprises for the high-performing stocks largely priced in. In
Europe, investors have also been increasingly conscious of the need to see hard
evidence of positive earnings growth emerging in order for equities to continue to
perform – so there is much at stake when 1Q reporting starts, and this may have
contributed to the more defensive sentiment and profit-taking in the market. Despite
some concerns regarding the impact of the currency on earnings, however, most
investors, like us, seem to expect 1Q reports in Europe to be positive.
There is much more to Momentum globally than the expensive Internet and Biotech
stocks that are being sold off – as evidenced not just by the straightforward read of the
sector composition of the baskets, but also by the fact that the overall style on both sides
of the Atlantic is now exceptionally cheap as we show below. We think that this should
support the performance of the factor, even if the unwinding of some expensive parts of
the market were to persist.
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MEDIA
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Emerging markets
The past two weeks have seen investors channel funds into emerging markets (EM) for
the first time in six months. This is a significant event given how extreme the negative
sentiment towards EM became in the past few months (indeed this extreme pessimism
regarding EM, which manifested itself in a rare ‘double redemption’ of funds both from
the dedicated GEM funds and the total of individual EM country funds, prompted us to go
long EM earlier this year (see Taking a long EM position, 4 February 2014). A number of
our clients have wondered whether the recent style rotation may have somehow been
connected with this change in sentiment towards EM.
Fig. 15: Flows into GEM funds, USD m
If there is a link between the improving sentiment towards EM assets and the relative
performance of styles in the US and Europe, we would expect this relationship to play
out via the domestically listed (ie, US and European) stocks with exposure to EM. In
Figs. 16-19 we look at the recent relationship between the daily relative returns of the
EM-exposed basket of stocks and the performance of Value and Momentum, in Europe
and the US.
European EM-exposed stocks indeed seem to have done well since mid-March,
outperforming the market by over 200bp, while Value did well and Momentum fell. This
relationship is in line with recent history – over the past year or so, the relative
performance of the EM-exposed stocks has been positively correlated with the
performance of Value in Europe, and negatively (if weakly) – with the performance of
Momentum.
Fig. 16: Relative performance of European stocks with EM exposure and the performance of Momentum
Fig. 17: Relative performance of European stocks wi th EM exposure and the performance of Value
USD million
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11
What about the US? As we would expect, with US companies in aggregate much less
exposed to EM than companies in Europe, these stocks do not appear to have moved
much in response to the resumption of flows into EM – and the relationship between their
relative performance and style performance has been weak or non-existent, both in the
past year and over the longer term. In particular, there has been a zero correlation
between the relative performance of the EM-exposed basket in the US and the
performance of Value over the past year or so, and a positive – though not very strong –
relationship between the EM-exposed basket and Momentum. Certainly, there was not a
sufficient move in these stocks in the past two or three weeks that could explain the large
drop in Momentum that we saw.
Fig. 18: Relative performance of US stocks with EM exposure and the performance of Momentum
Fig. 19: Relative performance of US stocks with EM exposure and the performance of Value
What do we conclude from all this? In Europe, the EM-exposed stocks have
underperformed over the past year – so in so far as some of these stocks have become
very cheap and ended up populating the Value basket, their outperformance when the
region started to benefit from inflows benefitted the performance of Value. Conversely,
Momentum may have been short some of these names, so their outperformance may
have hurt it. But with style constituents constantly changing, the relationship between
EM-exposed assets and style performance has been neither strong nor stable enough
historically for us to expect this effect to persist – even though we do believe that the
positive flows into the region may be sustained. Moreover, the EM effect does not shed
any light on what has gone on in the US – which, again, calls into question how
important it could have been in Europe given the synchronicity of the style moves in the
two regions.
Japan: a separate case
Japan has also seen some sizeable style moves over the past couple of weeks, but both
their direction and drivers have, as is usual for this market, been very different and
largely unrelated to what went on in the US and Europe. Specifically, there was a
concentrated unwinding of positions by active funds on 24 March, covered in detail in the
recent work by our Japan Quant team (see Concentrated position unwinding on 24
March 2014, 28 March 2014), which thinks that the selling was coming from the
Japanese active pension funds rather than global funds. In the two days that followed,
there was strong underperformance of parts of Value (low P/E stocks in particular sold
off strongly, in contrast to what we were seeing in the US and Europe around the same
time) and Growth and Momentum also underperformed. Interestingly, Momentum went
on to rebound in the days that followed to a greater extent than Value – again in contrast
to what happened in the US and Europe.
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Our Japan quant team argues that, although it is difficult to pinpoint the reasons for the
concentrated selling on those days, investors need to be aware of the possibility of the
same thing happening again. The dissolution of employee pension funds (EPFs) is about
to take place on a large scale – and, whether or not what occurred at the end of March is
linked directly to this process starting, the risk remains that a similar thing could happen
again. Domestic pension fund portfolios tend to be tilted toward Value factors, so the
longer-term effect of this is likely to be favourable for Momentum, Growth and
Profitability-related measures and negative for the efficacy of Value in Japan – a factor
that, historically, has performed the best there. Although the process is likely to be
gradual, it would mean profound changes for quant investing in Japan.
Doubling up on Momentum
None of the explanations that have been put forward to explain recent style moves give
us sufficient reasons to expect further underperformance from here. In fact, the sell-off
motivates us to double the size of our position, both in Europe and globally. The factor
was already trading at historical lows, and valuations have now become much more
extreme – after the recent rebalancing of the Momentum constituents and taking recent
moves into account, Momentum in Europe has become even cheaper, with the high-
momentum stocks trading at a 27% discount to low-momentum stocks on a price/book
basis. For ‘winners’ to trade at a discount to the ‘losers’ is a highly unusual event by the
very construction of the style, and has happened on only another two occasions in the
past 25 years. A discount of this size, is, simply put, unprecedented.
Globally, the factor is also very cheap, with the high-momentum stocks trading at a
premium to low-momentum stocks, which is very low by historical standards. Figs. 21
and 22 show the valuation of Momentum historically, with the ‘dots’ denoting the latest
valuations based on the new 2Q constituents and taking into account the factor’s
performance to the close of Monday 14 April.
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Fig. 21: European Composite Momentum, price to book
Source: Nomura Quantitative research. Figure shows price/book of the top quartile of stocks on our Composite Momentum measure relative to the bottom quartile of stocks.
Fig. 22: Global Composite Momentum, price to book
Source: Nomura Quantitative research. Figure shows price/book of the top quartile of stocks on our Composite Momentum measure relative to the bottom quartile of stocks.
A look at the previous draw-downs that the factor suffered in the past 25 years – which
we defined as periods of sustained underperformance amounting to 10% or more –
shows that on average these have happened when Momentum was nearly four times
more expensive than it is today, and have never happened from valuations at levels as
low as they are now. In fact, we showed in previous research that historically, similar
valuation levels were always followed by the factor outperforming on a six- and 12-month
view. (See Time to buy the winners, 7 January 2014.)
The factor should also benefit from continued support from the macroeconomic
environment; with the global economy continuing to progress through expansion, this
should be a favourable environment for the style. Lastly, its composition remains pro-
cyclical, and in line with our fundamental sector views, which also are unchanged, with a
preference for Financials and selected non-commodity cyclicals over defensives such as
Consumer Staples and Utilities.
One key thing to stress is that for long-short tactical investors with shorter holding
periods some caution needs to be exercised given that they seem to have suffered
particularly badly from the recent moves and that the ultimate cause of the sharp moves
like the one of 14 April is hard to pin down. Also, the move appears to have been
amplified by fund delivering, which is hard to predict and could potentially continue in the
very short term. As a call that is in large part driven by valuations, this is for investment
horizons of three months and beyond.
Our other factor calls are unchanged. We continue to prefer Risk over Quality, given that
quality stocks continue to trade at a large premium to risk stocks while seeing
intensifying downgrades. We have recently downgraded Value to neutral because of the
low valuation dispersion between value stocks and the rest of the market as well as the
overly bullish analyst expectation for these stocks. Lastly, we continue to discriminate
between growth measures (preferring the more cyclical expected growth factors to
sustainable growth) and are neutral on Size.
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
%
%

14
Of bonds and bubbles – value outperforms in rates, as in equit ies Value investing is nothing new. Especially in equities, value investing is among the
oldest and most well-known strategies. As early as 1934, Benjamin Graham and David
Dodd spelt out the principles of value investing in their text ‘Security Analysis’.
Academics such as Eugene Fama and Kenneth French have also studied value formally.
For example, Fama & French (1992) used value as part of their three-factor model of
stock returns. Legendary investors such as Warren Buffett and Seth Klarman famously
use the principles of value to guide their investment decisions.
At its core, value investing is simple: buy assets that are cheap, sell assets that are
expensive. Or as what Warren Buffett has observed in one of his letters, “whether we’re
talking about socks or stocks, I like buying quality merchandise when it is marked down”.
In this article, we focus on value in interest rates. We find that using techniques
fundamentally similar to those used in equities can help rates investors identify value,
across both curves and currencies. We discuss the following points:
• Value exists in both equities and interest rates.
• Carry in interest rates is analogous to earnings yield (E/P) in equities. Just as stocks
with high earnings yield outperform those with low earnings yield, curve points with high
carry outperform those with low carry.
• Comparing earnings yield both relative to its own history (time-series) and across
stocks (cross-sectional) is important to place current valuations in context. Similarly,
comparing carry on both time-series and cross-sectional basis is key.
• A long/short value strategy in rates outperforms a long-only benchmark. Being free to
trade the best points of value across curves and currencies, without constraining the
strategy to hold pre-specified pairs, can help make the strategy robust.
• Bubbles develop gradually, be it in equities or rates. Equities and rates don’t sell off
when they are cheap – crashes occur in the context of stretched valuations. Value-
signals can help track a build-up in overvaluation and identify when sell-offs in rates are
more likely.
• A long-only version of the value strategy outperforms a long-only benchmark on a
duration-matched basis. By going long the cheapest curve points across countries, the
strategy beats a static benchmark that holds the entire market.
• A short-only version of the value strategy can help hedge rising rates. It can also be
cheaper than being the short the entire market as it identifies the most expensive points
to be short rather than shorting all points.
• Value can outperform when momentum suffers. Momentum tends to underperform
when rates are close to zero and markets range-bound. In such trendless conditions,
value or mean-reversion trades tend to outperform.
Value works in both equiti es and rates
Assets that offer good value outperform those that do not. This appears to be equally
valid across equities and rates. In Fig. 23, we show performance of S&P 500 and G4
interest rate markets conditional on valuation. Both equity and rates outperform when
valuations are attractive relative to when valuations are poor. The question then is: how
to measure ‘value’? We will first look at some common measures of value in equities and
then extend the same fundamental approach to rates.
Tam Rajendran - NIplc

Source: Nomura research, Bloomberg
Value measures in equities
Common measures of value in equities compare the market price of a stock with
fundamental measures such as book value, forward or trailing earnings, and dividends, etc,
usually aggregated across a few quarters to smooth out short-term shocks. These are
sometimes further adjusted for business cycle and inflation effects, and compared with
long-term levels to gauge the valuation perception of current investors.
One common measure is the cyclically-adjusted price-earnings ratio (or CAPE; Campbell
and Shiller, 1988, 1998, 2001). Popularised by Nobel prize-winning economist Robert
Shiller, CAPE (sometimes referred to as Shiller’s P/E) looks at the ratio of real price to
real earnings smoothed over a 10-year period. A high P/E ratio indicates that current
market prices are high relative to earnings, perhaps suggesting overvaluation. Similarly,
a low P/E may suggest the market is undervalued. Fig. 24 shows historical Shiller’s P/E
for the S&P composite since 1900. Shiller’s P/E has been a robust indicator of valuation
in this period. The ratio has tended to be relatively high before large sell-offs, like in
1929, 1966, 2000 and more recently, in 2007. These were times of equity bubbles, when
prices were extremely high, and stocks expensive and overvalued. In contrast, the ratio
has been relatively low, indicating cheapness, just before significant bull markets, as in
1932, 1982 and 2009.
0.0%
0.1%
0.2%
0.3%
0.4%
0.5%
0.6%
0.7%
0.8%
0.9%
Equity
A v e r a g e m o n t h l y e x c e s s r e t u r n s ( % ) Good Value
0
1
2
3
4
5
6
7
Rates
A v e r a g e m o n t h l y e x c e s s r e t u r n
( b p )
Poor Value
40
400
0
10
20
30
40
50
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
S & P c o m p o s
i t e i n d e x
S h i l l e r ' s
P / E
1929
1966
2000
2007

16
A related and widely-used valuation measure is the earnings yield. It is calculated as the
ratio of earnings to price, ie, the inverse of P/E. Fig. 25 shows historical earnings yield for
the S&P composite since 1900. Stating valuation in yield terms offers a quick way of
comparing potential return both across individual stocks and different asset classes 3 .
Indeed, typical equity value strategies compare earnings yield both in a time-series and
cross-sectional sense.
Fig. 25: Low earnings yields means expensive equities
Source: Nomura research, Shiller’s website: www.econ.yale.edu/~shiller/
The relationship of earnings yield to expected returns has been documented in Basu (87)
and Ball (92) among others. Historically, earnings yield has proven to be a good proxy
for expected returns. High earnings yields tend to precede higher expected returns and
vice-versa. In Fig. 26, we show one-year ahead S&P returns conditional on current level
of earnings yield.
Fig. 26: Equities ou tperform when earnings yi elds are high
Source: Nomura research, Shiller’s website: www.econ.yale.edu/~shiller/ . Analysis based on data from 1900 to 2014.
We find that one-year ahead stock returns are the highest when earnings yields are in
the top quintile and weakest when earnings yields are in the bottom quintile. In other
words, measuring earnings yield relative to its own historical average can help place
current valuations in context. Earnings yields above historical average may mean
3 Dividend yield is a more direct measure, but is inadequate in practice owing to tax
considerations and variations in corporate payout policy. For example, companies may
favour stock buy-backs over dividends for issues unrelated to intrinsic valuation.
40
400
0.00
0.05
0.10
0.15
0.20
0.25
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
S & P c o m p o s
i t e i n d e x
E a r n
i e l d
1929
1966
2000
2007
0
4
8
12
16
S u
t S & P r e a
l r e
t t i m e
t + 1 ( %
, p . a . )
1y ahead

markets are undervalued (and vice-versa). Before using earnings yields to compare
different stocks or different markets, it may be important to standardise the indicator to
adjust for idiosyncrasies. Adjusting for the long-term average makes cross-sectional
comparisons consistent and robust.
In Fig. 27, we show a global equity value strategy that goes long stocks with high
earnings yield (cheap) and short those with low earnings yield (expensive). This strategy
has outperformed the MSCI World Equity index over the long sample.
Fig. 27: Global equity value strategy
Value measure in rates: carry as ‘earnings yield’
Carry in interest rates is analogous to earnings yield in stocks. Carry measures the
return on a bond assuming rates do not move. The relationship between current level of
carry and future bond returns is similar to that of earnings yield and stocks: points on the
curve with high carry tend to outperform those with low carry.
Similar to equity measures, adjusting carry for the long-term average can be important.
Carry measured relative to its own historical average (‘relative carry’) can help identify
times of potential overvaluation and undervaluation in interest rates and place current
levels in context. When carry is relatively low, it suggests future returns for bonds are
likely to be weak. Similarly, when carry is relatively high, future bond returns are likely to
be strong. In other words, low relative carry implies rates are expensive and offer poor
value, while high relative carry implies rates are cheap and offer good value. Fig. 28
presents the evidence across G4 markets. Rates have outperformed during period of
good value across curves and currencies.
Fig. 28: Rates outperform in periods of good value
Global Equity Value
-0.1
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
5y 10y 20y 30y 5y 10y 20y 30y 5y 10y 20y 30y 5y 10y 20y 30y
A v g .
t u r n
Top third Bottom third

18
We can now construct a value strategy in rates along the lines of equity value strategies.
We trade 5y, 10y, 20y and 30y interest rate swaps across the USD, GBP, EUR and JPY
curves. We measure carry as the 1m rolldown relative to its longer-term average at each
curve point. We then compare this indicator across the 16 possible curve points and go
long the top two points and short the bottom two points.
Fig. 29: Looking for value: searching across curves and currencies
Source: Nomura research. Positions shown current as of 14th April 2014
Such a value strategy has outperformed a long-only G4 government bond index
historically. The rates value strategy has higher Sharpe and Calmar ratios over the long
sample and in recent periods. It also has favourable skew characteristics.
Fig. 30: Rates value outperforms long-only – higher Sharpe and Calmar ratios, better skew
Source: Nomura research. Performance statistics are based on monthly returns from Jan 1992 to Feb 2014
We also scale the long/short exposure to a fixed-duration target to ensure the strategy
remains duration neutral. As a result, the final strategy has very little overall duration
exposure. The scatter plots below show monthly excess returns vs monthly changes in
10y yields across G4 markets. The long-only government bond index shows typical long-
duration behaviour – rising yields, negative returns and vice-versa. The rates value
strategy does not have any significant bias.
Low value High value
USD EUR GBP JPY
5y Long Short Long
1992 1997 2002 2007 2012
E x c e s s r e t u r n i n d e x
Rates value strategy
0.0
0.4
0.8
1.2
1.6
Entire sample Last 10 years Last 5 years Last 3 years
S h a r p e r a t i o
0.0
0.4
0.8
1.2
1.6
2.0
C a l m a r r a t i o
-1.0
-0.6
-0.2
0.2
0.6
1.0
S k e w

19
Fig. 31: Better returns, no bias – rates value outperforms despite flat-duration exposure
Source: Source: Nomura research, Bloomberg. Analysis based on data from 1992-2014
This can also be seen from the effective duration of the two strategies, calculated as the
negative coefficient of returns regressed on changes in yield. As expected, the long-only
bond index has a significantly positive duration of close to 5, while the value strategy is
practically flat duration exposure.
Searching for value across cu rves and currencies
In equities, earnings yield is a powerful tool used to estimate relative value and identify
opportunities for outperforming the benchmark. Valuation based on CAPE across
countries may be more robust as a metric for future returns compared with single-country
implementations (Faber 2012). By diversifying across a larger set, one is more likely to
diversify away idiosyncratic effect.
Similarly in rates, searching for value across curves and currencies provides the extra
diversification for long-term consistent outperformance. Allowing the strategy to choose
the best and worst curve points without constraining it to choose among pre-specified
cross-country pairs lets it adapt to changing yield curve dynamics. Also, comparing
current levels of carry relative to history helps place valuation in context and avoids
biased positioning. Using absolute levels of carry to position can prove to be misleading
and lead to an undiversified strategy. Fig. 32 shows the percentage of time a particular
curve point was selected. We find that the strategy that looks at relative carry is in
general well diversified. A strategy that uses absolute levels of carry would have never
picked most of the points and would have been heavily undiversified.
-3
-1.5
0
1.5
3
-1 -0.5 0 0.5 1 M o n t h l y e x c e s s
r e t u r n s
( % )
-3
-1.5
0
1.5
3
-1 -0.5 0 0.5 1 M o n t h l y e x c e s s
r e t u r n s
( % )
Effective duration

20
Fig. 32: Comparing carry against its own histo ry provides context to valuation, helps diversification
Source: Nomura research, Bloomberg. Analysis based on daily data from 2000, when data from all curve points become available.
Fig. 33: Using absolute levels of carry ignores current context, leads to biased positioning
Source: Nomura research, Bloomberg. Analysis based on daily data from 2000, when data for all curve points become available.
Evolving macro regimes can significantly affect the initial assumptions of a strategy. One
such example is the definition of the ‘belly’ of the curve. In the USD curve, it is common
to use the 5y point as the belly and reasonably so. This might not be the case in Japan.
Starting with the introduction of the zero interest rate policy by the Bank of Japan in
1999, the Japanese yield curve has become extremely flat out until the 10y point. The
front-end of the JPY curve can then be said to extend until the 5y or perhaps even
beyond until the 10y point. In such a scenario it might be inaccurate to treat the
Japanese 5y point as the ‘belly’ and expect it to have dynamics similar to the US 5y
point. With the Fed keeping short-term rates low, even US rates might be headed in the
same direction as Japan. The USD ‘belly’ too might move down the curve as front-end
rates become flatter.
Macroeconomic conditions change and curve behaviour reflects these changes. A rates
strategy, which has fixed assumptions about curves in its design, can underperform as
reality starts to differ from its initial assumptions. A strategy that is dynamic and is free to
move across curves and currencies can be more adaptive to the market.
Using value to identify sell-offs
Be it equities or rates, bubbles develop gradually; they rarely happen out of the blue.
Crashes occur when assets are expensive and valuations stretched. Equities do not
crash when they are cheap. Similarly, rates sell off not when they are cheap, but when
they have been consistently expensive and overvalued. Often, in periods of such
overvaluation, tell-tale signs show up in the data. Rules-based value strategies that stick
to following the data can help track a build-up in valuation. It can be difficult to time such
events perfectly, but sticking to simple and consistent valuation methodologies, and
having checks that compare along both time-series and cross-sectional basis can help
make the strategy robust.
We look at three cases of sell-offs in interest rate markets, all of which were thought to
be ‘sudden’ or ‘unexpected’ at that time: the inflation driven sell-off in the US in 1965, the
February 1994 sell-off in the US, and the so-called ‘VaR shock’ in Japan in June 2003.
But applying the techniques we describe in the previous sections, it seems rates were
indeed overvalued and were likely to crash in each of these cases.
The charts below show the 10-year yields in the respective countries. The colour of the
columns shows traded positions in that particular country; the columns in the top half are
long positions and those in the bottom half are the short positions.

Fig. 34: Case study 1: US sell-off i n 1965
Source: Nomura research, Bloomberg. Due to unavailability of swap rates data, bond yields have been used as proxy.
At the start of 1965, inflation in the US (gold line) was at a moderate 1% y-o-y. By the
end of the next year, it had reached around 3.5%. The value strategy was long the 20y,
and then later, the 5y point (blue and grey columns in the top half). But soon after, on the
basis of relative carry, USD rates began to appear expensive. In the latter half of 1965,
the strategy shifted to being short USD, just as yields began to rise. From then on, it was
consistently short USD rates through the 10y and 20y points (light and dark blue
columns in the bottom half). Positioning based on value would have helped capture most
of the sell-off.
Source: Nomura research, Bloomberg.
February 1994 saw the start of one of the largest sell-offs in US rates. 10y bond yields
rose by over 200bp in the course of that year. Although the sell-off was deemed to be
unexpected by most market participants, indicators of value told a different story. From a
valuation perspective, the strategy found US rates to be most expensive among the
sixteen points it looks at. Accordingly, the value strategy was short the 5y and 30y points
(grey and purple columns in the lower half). It continued to be short USD rates
throughout the year, switching to short 5y and 10y later and benefited from the sell-off.
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
5.5
-1
0
1
USD 20y
USD 10y
USD 5y
USD 10y (%, rhs)
US CPI (yoy, %)
S h o r t p o s i t i o n s i n
t h e U S
L o n g p o s i t i o n s i n
t h e U S
5.5
6.0
6.5
7.0
7.5
8.0
8.5
-2
-1
0
1
2
USD 30y
USD 20y
USD 10y
USD 5y
USD 10y yield, rhs, %
S h o r t p o s i t i o n s i n U S D

Fig. 36: Case study 3: Japan sell -off in 2003
The year 2003 started benignly for Japanese rates. The 10y point had continued its rally
and had fallen by around 35 bps in the first few months, reaching its all-time low in June.
But the strategy found valuations to be stretched and JPY rates expensive compared to
their own history and across markets. Based on this, it went short the 20y and 30y points
(dark blue and purple columns in the lower half). In June 2003, rates rose sharply and
sold-off by over 100 bps in a matter of months and reached a level of 1.6% in September
2003. The strategy, which was positioned short throughout this episode, benefited from
this sell-off.
The strategy continued to find JPY rates overvalued and remained short as rates
continued to rise into 2004. The sell-off finally cooled around the middle of 2004.
Interestingly, JPY rates began to look attractive at this point. The strategy found them to
be relatively cheap and undervalued. Towards the end of 2004, just as rates started to
rally, it went long JPY rates. As shown, the strategy went long the 20y and 30y points
predominantly (dark blue and purple in the top half) and the 10y at other times (light
blue).
Using value to outperform a long-only benchmark
The strategy described in the previous sections is long/short, based on value. It receives
interest rate swaps at the two cheapest curve points and pays interest rate swaps at the
two most expensive curve points. Receiving interest rate swap is equivalent to being
long a bond. But it is possible to only use the long part of the strategy. In Fig. 37 we
show a long-only variation of the value strategy described before. Based on relative
carry, the strategy searches for points across curves that offer the best value or are
‘cheapest’. It then buys these points, matching the duration to that of the benchmark.
Such a strategy has outperformed a long-only G4 government index. It has improved
returns and lowered the drawdowns, resulting in higher Sharpe and Calmar ratios.
0.0
0.2
0.4
0.6
0.8
1.0
1.2
1.4
1.6
1.8
2.0
-2
-1
0
1
2
JPY 30y
JPY 20y
JPY 10y
JPY 5y
i t i o n s
i n
i t i o n s
i n

Fig. 37: Long -only value strategy outperforms a long-only benchmark
Source: Nomura research, Bloomberg. Both strategy and long-only index have been scaled to have the same annualised volatility for easier comparison.
The outperformance is largely attributable to two things the strategy does differently.
First, it trades interest rate swaps instead of bonds. Trading swaps offers an immediate
pickup in yield over trading bonds. Second, it dynamically looks for the best points to be
positioned long across the curve. Selectively being long the part of the curve that is
cheapest can help outperform a benchmark that statically holds the entire curve. After
all, the benchmark does not distinguish between expensive and cheap, between good
value and poor value.
Using value to hedge rising rates
The counterpart to the long-only part of the value strategy is to trade only the short
positions. The short-only value strategy sells the two most expensive curve points across
curves, providing a cheaper way to hedge rising rates than going short the entire market.
In Fig. 38 we compare such a strategy to a short-only G4 government bond index (the
negative of the long-only index used in the previous section). As before, the strategy has
been targeted to have a duration similar to that of the bond index.
90.0
Long-only value strategy (top 2) Long-only G4 govt. bond index
1992-2014 2000-2014 2011-2014
Volatility (%) 4.55 3.17 5.11 3.38 4.49 3.64
Sharpe 0.95 0.85 0.93 0.73 1.19 0.93
MDD 8.55 8.42 7.22 6.84 4.28 4.60
Calmar 0.51 0.32 0.66 0.36 1.25 0.73

24
Fig. 38: Short-only value strategy out performs a short -only index
Source: Nomura research, Bloomberg. Both strategy and long-only index have been scaled to have the same annualised volatility for easier comparison.
The short-only value strategy bleeds much less than the short-only bond index. It also
has much lower drawdowns and better returns. Fig. 39 highlights the source of gains.
When rates are rising, it delivers returns almost on par with being short the entire market.
But, more importantly, when rates are falling, it loses only half as much being short the
market. It offers a cheaper way to protect against rising rates.
Fig. 39: Short-only value offers a cheaper way to hedge rising rates
Source: Nomura research, Bloomberg. Analysis based on monthly returns from 1992-2014.
Using value to outperform in trendless markets
Like a long straddle position, momentum requires large moves in either direction to
perform. If interest rates remain low and markets range-bound, such trading rules will
suffer. For example, before Bank of Japan introduced its zero rate policy in 1999,
momentum strategies worked well in JGB futures. Since 1999, however, such strategies
have failed to perform. Instead, value strategies that trade on mean-reversion in JGB
futures have started to outperform. The figure below shows the performance of
momentum and value strategies in JGB futures.
50
Short-only value strategies (bot tom 2)
Short-only G4 govt. bond index
1992-2014 2000-2014 2011-2014
Volatility (%) 3.40 3.17 3.21 3.38 2.70 3.64
Sharpe -0.24 -0.85 -0.23 -0.73 0.00 -0.93
MDD 23.38 46.74 16.34 31.67 7.50 13.81
Calmar -0.04 -0.06 -0.04 -0.08 0.00 -0.24
-1
-0.6
-0.2
0.2
0.6
1
Months of negative LO returns Months of positive LO returns
A v g .
m o n
t h l y e x c e s s r e
t u r n s
( % )

25
Fig. 40: Momentum has underperformed while Value has outperformed in Japan post- ZIRP
Source: Nomura research, Bloomberg. Both strategies have been scaled to have the same volatility for easier comparison
This has been evident in global markets more recently. With global yields at historical
lows, interest rate markets have remained trendless. As a result, trend-following
strategies like momentum have underperformed. In contrast, value strategies have done
very well. The chart below shows performance of value and momentum strategies
across G4 markets last year.
Fig. 41: Value outperformed Momentum in G4 rates in 2013
Conclusion
Value strategies in equities have been popular for decades. Typical value strategies in
equities use earnings yield as a measure of valuation. Earnings yield compared to its
own history and across markets helps place current valuations in context and to identify
expensive/cheap stocks. In interest rates, carry is similar to earnings yield. Just like in
equities, comparing carry to its own history and across curves can help identify points of
overvaluation or undervaluation. A value strategy in interest rates based on such a
measure has outperformed over time, delivering higher returns and lower drawdowns
compared to a long-only benchmark.
Value strategies can be useful in many different ways. By tracking measures of value the
strategy can help identify times when valuations are stretched and rates likely to sell-off.
A long-only value strategy can also help beat a long-only benchmark by selecting points
that are cheap and undervalued to go long instead of being long the entire market. Its
opposite, the short-only value strategy can help hedge rising rates better than a strategy
that is short the entire market, as it shorts only points that are overvalued and expensive.
80
100
120
140
160
180
ZIRP begins
JGB momentum
JGB value
G4 rates value
G4 rates momentum

26
Also, when rates are close to zero and markets range-bound, momentum strategies may
underperform. However, in these trendless environments, value strategies tend to
outperform.
The essential truth of value – to buy assets that are cheap and sell assets that are
expensive – is universal. It works in equities and also in rates. Borrowing fundamental
techniques of valuation from equities and applying them to interest rates can help design

27
References
• Asness, C.S., Moskowitz, T.J., and Pedersen, L.H. (2013), “Value and Momentum
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• Ball, R. (1992), “The earnings-price anomaly,” in Journal of Accounting and Economics
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• Basu, S. (1977), “Investment Performance of Common Stocks in Relation to Their Price
to earnings Ratios: A Test of the Efficient Market Hypothesis,” in Journal of Finance 32,
663-682
• Campbell, J.Y., and Shiller, R.J. (1988), “Stock Prices, Earnings, and Expected
Dividends,” in Journal of Finance 43, 661-676
• Campbell, J.Y., and Shiller, R.J. (1998), “Valuation Ratios and the Long-Run Stock
Market Outlook,” in Journal of Portfolio Management 24, 11-26
• Faber, M.T. (2012), “Global Value: Building Trading Models with the 10 year CAPE,” in
Cambria Quantitative Research, No.5, August 2012
• Fama, E.F. and French, K.R. (1992), “The cross-section of expected stock return,” in
Journal of Finance 47, 427-465
• Frazzini, A., Kabiller, D. and Pedersen, L.H. (2013), “Buffett’s Alpha,” NBER Working
Paper No. w19681

28
Concentrated position unwinding on 24 March • From 24 March 2014 through the morning’s trading session on 25 March, actively
managed Japanese equity funds faced a relatively strong headwind, especially in large
cap universes. Strategies based mainly on analyst earnings forecast-related factors
and stocks with high active fund ownership ratios produced negative returns of less
than -3% over this period. It is highly probable that, for some reason, there was a
concentrated spate of selling for position unwinding purposes by active funds on those
two days. The sell-off appears to have come to an end before the start of the afternoon
trading session on 25 March, but we think there is still a need for caution.
• We all remember the "quant headwind" in August 2007, when selling pressure was
similarly concentrated on certain investment styles, such as E/P-based factors, and the
performance of a number of factors plummeted at the same time in multiple markets
around the world. This time around, however, we think the sell-off was due not to the
unwinding of positions by global funds but to selling by Japanese active pension funds.
• While it is difficult to pinpoint the reasons for selling by Japanese active pension funds,
we think investors need to be aware of the possibility of a similar thing happening
again. One reason for this view is that the dissolution of employee pension funds
(EPFs) is about to take off on a large scale. Whether or not what happened on 24–25
March was linked to the return to the state of the substitutional portions of EPFs, the
risk remains that a similar thing could happen again. A positive way of looking at what
happened on 24–25 March would be to say that it has served as "disaster training" in
preparation for the risk of future unwinding of pension fund positions.
• Based on this view, we would like to stress the importance of avoiding stocks that are
the object of herding by active funds. For example, if we assume that there is a
substantial unwinding risk for stocks in which only domestic pension funds are
substantially overweight, then avoiding these stocks is likely to be an effective strategy.
This kind of strategy would have performed well from mid-January 2014 onward, and
would have generated positive returns without suffering a negative impact on 24 March
2014.
1. Unwinding of Japanese large caps
On 24 March and in the morning trading session on 25 March, managers of active
Japanese equity funds were hit by a headwind. In this chapter we look at the intraday
performance of the major quant factors for Japanese equities on 24 and 25 March. The
analysis set out below shows that large caps suffered the greatest losses and strategies
based mainly on analyst earnings forecast-related factors and stocks with high active
fund ownership ratios produced returns of around -2% on 24 March and around -1% in
the morning session on 25 March. It is highly probable that, for some reason, there was
a concentrated spate of selling for position unwinding purposes by active funds on those
two days.
1.1 Headwind for active fund managers
We look first at the performance of key quant factors on 24 March 2014. We divided our
two universes—large caps (TOPIX 500 stocks) and small caps (listed stocks with market
caps of ¥10–200bn)—into quintiles based on factor values as of the beginning of March
2014. For each universe, we then calculated the daily return (equally weighted basis) on
24 March on a strategy comprising long positions in the stocks in the quintile with the
highest factor values and short positions in the stocks in the quintile with the lowest
factor values.
Fig 42 shows the results. Estimated E/P, a valuation-related factor, and expected ROE, a
growth-related factor, generated substantial negative returns, particularly for large caps.
Estimated E/P generated returns of -1.96% and -1.25% for large caps and small caps,
respectively, while expected ROE generated returns of -1.76% and -0.8%, respectively.
The active fund ownership ratio, which is the supply and demand factor that we think
requires the most attention, generated the lowest daily return for large caps on 24 March
of all the factors we examined, at -2.4%.
Akihiro Murakami - NSC

29
What happened in the Japanese equity market on 24 March, just ahead of the fiscal
year-end, has no doubt caused problems for fundamentals-based active fund managers.
Not only did strategies based on analyst forecasts, which many active fund managers
favor, fail to function, but active fund managers also saw a sharp deterioration in the
performance of many of the stocks in their portfolios.
Fig. 42: Factor returns on 24 March 2014
Note: Based on TOPIX 500 stocks for large caps and listed stocks with market caps of ¥10–200bn for small caps, as at the time of rebalancing at the beginning of each month. For each factor, we divided each universe into quintiles based on factor values , and calculated the daily return (equally weighted basis) on 24 March, including dividends, on a strategy comprising long positions in the stocks in the quintile with the highest factor values and short positions in the stocks in the quintile with the lowest factor values. We did not take sector allocation into account. Top three factor returns are shown in red, bottom three are shown in blue.
Source: Nomura
1.2 Selling for position unwinding purposes ended before afternoon session on
25 March
We look next at intraday performance on 24 and 25 March. Our analysis indicates that
selling that appeared to be for position unwinding purposes by active funds, which
started when the market opened on 24 March, came to an end before the afternoon
session on 25 March.
We now look at intraday factor performance in order to analyze the situation in more
detail. Our analysis methodology is the same as in Section 1.1.
Fig. 43 shows intraday factor returns on 24 March 2014. While the TOPIX rose sharply
and the mood in the market as a whole appeared to be, if anything, rather optimistic
(Fig.43 (c)), active fund managers were having a difficult time.
Fig. 43 (a) shows how low-P/E stocks were sold off from the start of trading on 24 March
and saw share price declines of around 1% in the morning session and another 1% or so
in the afternoon session. Similarly, Fig. 43 (b) shows that stocks with high active fund
ownership ratios suffered further price declines in the afternoon session.
Factor return as of 24 March 2014 (%)
Factor Large cap (Ranking) Small cap (Ranking)
Valuation Estimated E/P Undervalued – overvalued -1.96 (27) -1.25 (28)
B/P Undervalued – overvalued 0.39 (5) 0.20 (15)
Estimated dividend yield High – low -0.69 (17) -0.68 (26)
Time series normalized E/P Undervalued – overvalued 0.70 (4) 0.38 (9)
Time series normalized B/P Undervalued – overvalued 0.77 (3) 0.67 (6)
Growth Expected ROE High – low -1.76 (26) -0.80 (27)
Expected pretax profit margin High – low 0.85 (2) 0.62 (7)
Recurring profit growth High – low -1.06 (20) 0.35 (10)
Quality Total accruals Quality low – high -0.02 (7) -0.01 (19)
Merton default probability High – low -0.13 (10) 0.77 (4)
Size Market cap Large – small -1.21 (23) 0.77 (3)
Historical return Historical 1-month return High – low -0.04 (8) 0.24 (13)
Historical 3-month return High – low -0.20 (11) -0.59 (24)
Historical 6-month return High – low -0.82 (19) 0.02 (17)
Historical 12-month return High – low -1.09 (21) 0.22 (14)
Risk Fundamental beta High – low -1.11 (22) 1.33 (1)
Specific risk High – low -0.44 (14) 0.14 (16)
60-day volatility High – low -0.57 (16) 1.29 (2)
Supply/demand Active fund ownership ratio High – low -2.40 (28) -0.01 (20)
Nonresident ownership ratio High – low -1.38 (24) 0.75 (5)
Pension investment trust ownership ratio High – low -1.46 (25) 0.27 (12)
Individual investor ownership ratio High – low 1.02 (1) 0.34 (11)
Net equity finance High – low -0.09 (9) 0.01 (18)
Consensus forecast Change in recurring profits High – low 0.08 (6) 0.58 (8)
Change in rating High – low -0.45 (15) -0.63 (25)
Change in target price High – low -0.33 (12) -0.06 (21)
Earnings surprise Y-y change in quarterly progress High – low -0.77 (18) -0.53 (23)

30
This trend continued into the next day, with similar phenomena observed at least through
the morning session of 25 March as on 24 March (Fig. 44 (a) and (b)). The return on
estimated E/P fell a further 1% or so in the morning session, while the active fund
ownership ratio factor generated a return of less than -1%. However, these trends were
reversed immediately after the start of trading in the afternoon session on 25 March, and
both low-P/E stocks and stocks with high active fund ownership ratios were bought back.
The selling thought to be for the purpose of position unwinding by active fund managers
that began at the start of trading on 24 March thus appears to have come to an end
before the afternoon session on 25 March. However, we think investors need to remain
aware of the risk that a similar sudden deterioration in the supply/demand balance might
occur again.

Fig. 43: Intraday factor retu rns on 24 March 2014
Estimated E/P
c) TOPIX
Note: Based on a universe of TOPIX 500 stocks. For each factor, we divided the universe into quintiles based on factor values at the beginning of March 2014. We then calculated the intraday return (equally weighted basis) and intraday turnover ratio on 24 March on a strategy comprising long positions in the stocks in the quintile with the highest factor values and short positions in the stocks in the quintile with the lowest factor values. We did not take trading costs into account. Analysis is based on historical data and does not guarantee future performance.
Source: Nomura
x 10 -8 (%)
09:00 09:30 10:00 10:30 11:00 11:30 12:00 12:30 13:00 13:30 14:00 14:30
- 2
- 1.5
- 1
- 0.5
0
Intr aday factor return (lhs) and in traday turnover ratio (rhs)
0
1
2
3
4
5
6
7
8
9
x 10 -8(%)
09:00 09:30 10:00 10:30 11:00 11:30 12:00 12:30 13:00 13:30 14:00 14:30
-2
-1.5
-1
-0.5
0
Intraday factor return (lhs) and in traday turnover ratio (rhs)
09:00 09:30 10:00 10:30 11:00 11:30 12:00 12:30 13:00 13:30 14:00 14:30 0
0.5
1
1.5
2

Fig. 44: Intraday factor retu rns on 25 March 2014
(a) Estimated E/P
(c) TOPIX
Note: Based on a universe of TOPIX 500 stocks. For each factor, we divided the universe into quintiles based on factor values at the beginning of March 2014. We then calculated the intraday return (equally weighted basis) and intraday turnover ratio on 25 March on a strategy comprising long positions in the stocks in the quintile with the highest factor values and short positions in the stocks in the quintile with the lowest factor values. We did not take trading costs into account. Analysis is based on historical data and does not guarantee future performance.
Source: Nomura
09:00 09:30 10:00 10:30 11:00 11:30 12:00 12:30 13:00 13:30 14:00 14:30
-0.6
-0.4
-0.2
0
0.2
0.4
0.6
(%) Intraday return
09:00 09:30 10:00 10:30 11:00 11:30 12:00 12:30 13:00 13:30 14:00 14:30 0
1
2
3
4
5
6
7
(%) Intraday factor return (lhs) and int raday turnover ratio (rhs)
09:00 09:30 10:00 10:30 11:00 11:30 12:00 12:30 13:00 13:30 14:00 14:30 0
1
2
3
4
5
6
7
8
-1.4
-1.2
-1
-0.8
-0.6
-0.4
-0.2
0

The selling pressure concentrated on E/P-based factors and other specific investment
styles that we saw in the Japanese equity market on 24 March was reminiscent of the
"quant headwind" in August 2007 4 , when the performance of similar factor strategies
plummeted simultaneously for a short period of time in a number of markets in the US,
Europe, Japan, and Asia. Below, we set out our analysis of whether what happened on
24–25 March was due to the unwinding of positions by global funds or simply due to
domestic factors (such as domestic fund cancellations). We conclude that what
happened on 24–25 March was linked to the unwinding of positions by domestic pension
funds. This is because we were unable to confirm a correlation in global factor
performance during the period around 24 March, unlike for August 2007, and there was
also a marked deterioration in the performance of domestic pension portfolios in March,
as performance data for Japanese equity investments by investor category show.
Even if the unwinding of positions by Japanese pension funds was the direct cause of
what happened on 24–25 March, as we suspect, it is difficult to pinpoint the exact
reasons for this. However, we need to bear in mind that the dissolution of EPFs is about
to get fully under way. We cannot rule out the possibility that what happened on 24–25
March was related to EPF dissolution, but whether or not this was the case, a risk clearly
remains that a similar thing will happen again. This is because EPF dissolution is
scheduled to take place over the next five years, and is likely to have multiple peaks.
Taking a positive view, we could see the recent spate of position unwinding as "disaster
training" in preparation for the risk of further unwinding of pension fund positions in the
future. We would therefore like to stress the importance of avoiding stocks subject to
herding by active funds. For example, assuming there is a high risk of unwinding for
stocks in which only domestic pension funds are substantially overweight, we think
avoiding these stocks is likely to be an effective strategy. This kind of strategy would
have performed well from mid-January 2014 onward, and would have generated positive
returns, without suffering any negative impact from the spate of unwinding on 24 March
2014.
2.1 No sign of a connection with unw inding by global funds
We now compare the recent selling pressure thought to be due to the unwinding of
positions by active funds with what happened in August 2007 in order to investigate
whether th

doubling up on momentum

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