The investment landscape has changed, with an era of "cheap money"1 and "seemingly unlimited liquidity" having come to an end.2 The accommodative monetary policies that defined the past three decades—and particularly the two years following the start of the pandemic—are, in our view, being replaced with less-accommodating conditions.3 These include higher interest rates, more impactful macroeconomic risk, and geopolitical fractures from which investors cannot be shielded.
Against this backdrop, the assessment of risk has become more complex, while the ease of generating returns has become more challenging as the gap between winners and losers widens. In this (return to) normal market environment, we believe a multi-factor quantitative approach—one that avoids macro risk exposures and allows idiosyncratic company attributes to drive decision-making—is well positioned to thrive.
Easy Money Created Ever-Greater Extremes in Investor Preferences
In our view, the past three years have been a case study in behavioral finance: As central banks around the world once again stepped in to save companies from failing and economies from collapsing, investors' perception of risk appeared to become distorted. A company unable to pay its debts, for instance, might fit the technical definition of bankruptcy—but the willingness of lenders to roll over corporate debt made the threat of bankruptcy seem ever lower. We then observed an increase in appetite for high-risk, often loss-making, companies as the difficulty to access reasonable returns elsewhere drove increasingly extreme trading behavior. Buying high-risk, high-growth, loss-making enterprises has historically not been a recipe for investment success—yet from 2016 to 2020, it was highly successful, delivering a 9.65% annualized return versus that of the market. In 2020 it reached its apex, with high-growth loss-makers outperforming by 31% over the year (Exhibit 1). Elsewhere, we witnessed the advent of meme stocks: stocks that were bid up to extremely high levels, primarily due to hype rather than underlying performance or fundamentals.4 The meme stock phenomenon represents an extreme example of what happens when investors' perception of risk becomes skewed.
EXHIBIT 1
High-Growth Loss-Makers: A Recipe for Success?
As of 22 November 2023
Source: Lazard, FactSet, MSCI, S&P
Price Instability during COVID Period Upends Previously Held Assumptions
We see the regime we're entering now as entirely different. Macroeconomic and geopolitical challenges are mounting while high liquidity is drying up, making investment risk assessment both more important and more challenging. On top of this, consumer price stability has come into question for the first time in decades due to the return of surging inflation (Exhibit 2). This price instability is leading to significantly more volatility in the risk-free rate according to the ICE BofA MOVE Index, which measures expected volatility in government bond yields and has long served as a bellwether of changes in broader risk appetite (Exhibit 3). Ultimately, we have seen this increased risk aversion reflected in the way both central banks and investors assess longer-term inflationary risks.
EXHIBIT 2
The Surge in Core Inflation...
As of 30 September 2023
Source: Lazard, FactSet
EXHIBIT 3
...Has Led to Much Higher Volatility in the Risk-Free Rate
As of 22 November 2023
Source: ICE BofA MOVE Index
Forecasting financial performance is a difficult endeavor even in calmer periods, but changing economic conditions have exacerbated the challenge. Standard metrics of financial performance, like cash flow, become less predictable in times of economic uncertainty, raising questions about the true equity value of a business. This uncertainty can have ripple effects: It may lead to higher levels of market volatility, which can in turn lead to higher tracking error—the performance of a portfolio relative to the benchmark—in actively managed portfolios. We believe this is resulting in risk exhaustion: the sense that pricing pools of assets has become markedly more difficult, with far higher downside risks, and achieving reasonable real returns is now an uphill challenge.5
Risk Aversion Returns
In this environment, the simple concept of "buying good businesses" is not so simple. In our view, the standards for justifying valuations have become much higher, and investors must apply more scrutiny to companies' leverage levels, paths to profitability, and ability to survive in a more volatile economic environment. In the last 18 months alone, we have seen a sharp increase in the risk-free rate, underscoring the rising bar for risk-taking and corporate decision-making. We are seeing less patience (and greater punishment) on the part of investors, who seem increasingly unwilling to tolerate uncertain paths to profitability over extended periods. We see this in the underperformance of high-growth companies from 2021 to 2023, marking a reversal of pandemic-era enthusiasm (Exhibit 4). It also appears to be reflected in the underperformance of small caps versus large caps, with higher risk premiums now being applied to smaller companies that likely lack the scale and history that can help investors feel secure in a more uncertain world (Exhibit 5).
EXHIBIT 4
High-Growth Companies Give Back Returns
As of 30 September 2023
Source: Lazard, FactSet
EXHIBIT 5
Small Cap Underperformance since 2020
As of 30 September 2023
Source: FactSet, Lazard
A Core, Highly Risk-Controlled Approach Is Inherently Well Equipped to Cope with Uncertainty
As investors seek to navigate this more normal market, we believe a multi-factor quantitative approach will increasingly serve as the foundation of many equity portfolios. These strategies are more diversified and less volatile, exhibit tighter tracking error, and can transcend the narrowly defined styles of value, growth, and quality that tend to cycle in and out of favor. The strategies focus on high-quality balance sheets and strong growth prospects, with bottom-up, active stock picking—and more diversified, risk-controlled portfolios—driving every decision.
Risk premiums are already on the rise, and we expect this to continue in the years ahead as less supportive monetary policy and higher risk-free rates become the norm. We are already seeing shifts in the way different styles are performing in this new environment, and we believe this is the ideal moment for the systematic application of a core investment philosophy to truly show its worth.
1 "The end of cheap money reveals global debt problem," Reuters, accessed 4 December 2023
2 "Joe Zidle: The End of Liquidity Is a New Beginning for Alpha," Blackstone
3 "The monetary policy response to COVID-19," United Nations, accessed 4 December 2023
4 "Explainer: What are meme stocks?," World Economic Forum, accessed 4 December 2023
5 "Exhaustion Gap: Definition, How to Recognize, Trading and Advantages," Strike Blogs, accessed 4 December 2023
Important Information
Published 6 December 2023
For Financial Professional Use Only. Not for Public Distribution.
Information and opinions presented have been obtained or derived from sources believed by Lazard Asset Management LLC or its affiliates (“Lazard”) to be reliable. Lazard makes no representation as to their accuracy or completeness. All opinions expressed herein are as of the published date and are subject to change.
The performance quoted represents past performance. Past performance is not a reliable indicator of future results.
Allocations and security selection are subject to change.
Mention of these securities should not be considered a recommendation or solicitation to purchase or sell the securities. It should not be assumed that any investment in these securities was, or will prove to be, profitable, or that the investment decisions we make in the future will be profitable or equal to the investment performance of securities referenced herein. There is no assurance that any securities referenced herein are currently held in the portfolio or that securities sold have not been repurchased. The securities mentioned may not represent the entire portfolio.
Equity securities will fluctuate in price; the value of your investment will thus fluctuate, and this may result in a loss. Securities in certain non-domestic countries may be less liquid, more volatile, and less subject to governmental supervision than in one’s home market. The values of these securities may be affected by changes in currency rates, application of a country’s specific tax laws, changes in government administration, and economic and monetary policy. Small- and mid-capitalization stocks may be subject to higher degrees of risk, their earnings may be less predictable, their prices more volatile, and their liquidity less than that of large-capitalization or more established companies’ securities.
A quantitative investment strategy relies on quantitative models and quantitative filters, which, if incorrect, may adversely affect performance.
The ICE BofA MOVE Index is a yield curve weighted index of normalized implied volatility on one-month Treasury options. The index is unmanaged and has no fees. One cannot invest directly in an index.
The indices referenced in this document are included merely to show general trends in the market during the periods indicated and are not intended to imply that investments made pursuant to the strategy are or will be comparable to any index in either composition or element of risk. The strategy is not restricted to securities comprising any index. The strategy may use various investment techniques not reflected in an index. The indices referenced herein are unmanaged and have no fees. One cannot invest directly in an index. There is no guarantee that the strategy’s performance will meet or exceed any index.
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