At Atlas Capital, we’ve been promoting the merits of factor-based investing for ten years. We emphasize portfolios leveraging well-established risk factors: momentum, size, value and short-term reversal. However, we also recognize there may be exogenous seasonal influences on stock prices. One of the influences observed is known as the “calendar effect” because of how factor performance varies over the course of a calendar year.
The table below breaks out monthly factor based returns since 1951 relative to the broad equity market. It is apparent that value and size tend to underperform in Q4 and outperform in Q1. A solution for client portfolios: overweight momentum and underweight size and value for Q4. Subsequently, reverse this weighting in Q1 of the following year.
Erroneous strategies can come from over-dependence on “data mining” analysis and results. None of our strategies are real unless there is reason why they will continue to be effective in the future. Data alone can be deceiving. Logic for the calendar effect is fairly simple: tax loss harvesting and window dressing. Tax loss harvesting strategies often perpetuate momentum effects as losing stocks are subject to additional selling pressure prior to year-end. Additionally, investment managers (especially institutional professionals) don’t like to have their year ending reports populated by poor performing stocks, preferring ‘great’ companies with high valuations. Never give the fund board more ammunition to fire you. At the start of the year, investors realize they are holding stocks that have benefited from unsustainable momentum (and are thus relatively overvalued) and trade into more reasonably priced stocks; value and small cap outperform.