Last week’s column addressed the VIX futures curve and the Iran situation; the short version is that front-end backwardation with the M3–M6 contracts still in contango reads as a discrete geopolitical shock, not a structural regime change. Worth reading if you missed it. Today’s question is simpler and more actionable: when systematic funds detect a regime shift, what actions do they take?

One thing they don’t do: They don’t just wait until the talking heads on the cable TV investing shows announce a market meltdown to the masses. And they don’t wait for opportunities to pass them by. At least, not on purpose, anyway!

Instead, they rotate their factor exposures. Even if it means taking a capital gains tax hit, in some cases.

In this installment, we’ll look at what I mean when I say “factors,” how systemic funds balance their exposures and react to perceived changes in the market environment. Here is the documented playbook - what it is, what history shows, and what the evidence says the best managers are doing right now.

Forget what you know about stock and fund categories and sectors for now. Sure, they are very useful concepts. But they don’t quite capture how systematic fund managers view the investment landscape.

Instead, let me introduce you to the “four factors” of equity investing, as systemic managers see them:

Sure, you can quibble endlessly with these categories. Some people add a fifth, emphasizing income, or they add a currency or political risk dimension through international exposure. And those are useful diversifiers, too. But these four factors are still the fastball, curveball, slider, and changeup of the equity investment world, at least for the systematic fund community. Thinking in terms of these four factors can go a long way in helping you build a mental model to guide your own portfolio and allocation decisions.

In fact, these are the broad categories that successful systematic houses like AQR, Man Group, and others have built their track records on and have successfully implemented at scale.

Historically, when the Treasury yield curve normalizes after a long period of inversion, three of these four factors - high-quality, low volatility, and value - don’t even break a sweat.

But for the momentum factor, it’s quite a different story.

Drawing on data from Ken French’s research at Dartmouth University, based on monthly S&P 500 returns dating back to 1926, things can get ugly indeed for the momentum factor in the months following the normalization of a long-inverted Treasury yield curve.

They typically continue to outperform for a few months after normalization and then take a nosedive.

Here’s a rough look at what each of the four factors has done in the months after three recent yield curve normalizations following long periods of inversion:

In each of these three graphics, the line graph starts at the point of yield curve normalization.

High -quality and low-volatility stocks are indicated by the green and blue lines; momentum assets are in orange.

In each cycle, momentum held briefly after un-inversion - sometimes surging for six to nine months - and then underwent a sharp collapse, making Warren Buffett look smart again.

In contrast, quality and low-volatility assets often decline modestly during the momentum surge, then outperform through the recession and beyond.

The 2000–01 momentum collapse was among the worst on record for the momentum factor, coinciding with the Dot-Com bust. And, of course, the 2007–08 cycle matched it in severity, though it took out a lot of financial and mortgage-related stocks that looked invincible during the run-up.

In each of these three cycles, momentum held up briefly after un-inversion, then weakened, while quality and low-volatility assets held up better through the downturn.

Structurally, index funds - and by extension, retail investors in general - are nearly always overweight in momentum assets, where the momentum factor is defined as “what’s been working recently.”

Since broad index funds are weighted by market cap, it’s the companies and sectors with recently expanding market caps that throw their weight around. But these aren’t a factor of earnings. They’re a factor of multiples. And companies that have yet to turn a dime in profit or dividends for investors can still grow to occupy an outsize portion of stock market indexes.

When this happens, index and retail investors wind up dangerously overexposed to the momentum category - and underweight in the high-quality and low-volatility factors.

Everything seems hunky-dory… until regime change hits. Risk then becomes actualized, rather than hypothetical. And retail investors lose their shirts.

Meanwhile, the successful systemic managers who pay attention to regime change indicators such as the normalization of the yield curve, backwardization of the VIX futures curve, and the increasing correlation between stocks and bonds, have long-since jettisoned much of their momentum-driven assets, having already squeezed the juice out of the momentum category, and are sitting pretty in the high-quality, low-volatility assets that are poised to dominate the markets.

Or, so they hope, anyway!

If this stuff were easy, everybody would be doing it!

Systematic funds don’t publish their portfolios in real time. And some, like the incredibly successful Medallion Fund, don’t publish them at all. So we can’t observe their portfolio decisions directly. However, these institutions sometimes give us some insights into their broad strategic approaches, and their assessment of emerging regime changes.

Or the lack of them, as the case may be.

Let’s look at a couple of the top investors in this space: AQR (particularly their Delphi strategy) and Man Group.

*Interestingly, AQR’s Delphi strategy is, itself, a thematic bet on stockpicking over thematic bets!

Stock prices, in theory, are based on the market’s estimate of the present value of future cash flows to investors.

But some stocks have more uncertain cash flows in the out years than others. For example, the Magnificent Seven, whose valuations depend on earnings projected a decade or more forward, can trade like long-duration bonds.

When markets rotate away from momentum stocks, the pivot toward quality and low volatility is partly a pivot toward shorter “equity duration.” That is, it favors companies whose value comes from earnings that exist today, not earnings projected ten years out. Most retail portfolios have no idea what their equity duration is. But it’s worth considering how things went in 1999 and 2000, when markets made a habit of valuing Internet and tech companies based on 20 of them each having 25% market share in five years.

That math didn’t math.

And it can’t math this time around, either. Though, as we know, crazy valuations can persist for much longer than the shorts can stay solvent.

Here are three takeaways for you to focus on as we head into Spring:

Interestingly, despite high volatility in both equities and energy prices, credit spreads have hardly budged at all. In fact, they’re quite tame: High-yield spreads sat near approximately 3% before the Iran shock - against a long-run average of roughly 5–6%.

Either credit markets are right, and the Iran War energy crisis will be short-lived… or credit will simply be the last to move, as it was in 2006–07. The Iran shock may accelerate the credit signal or temporarily obscure it.

We’ll take a closer look at the credit spread indicator… next week.

DISCLOSURE: This article is for informational purposes only and does not constitute investment advice. Factor return sequences in Figure 1 are directionally grounded in Ken French’s published monthly data but represent reconstructed approximations for illustrative purposes. Verify against primary source data before publication. Past performance is not indicative of future results.

Until next time,

The Navigator