Unhedged Commentary

Friday, December 16, 2016

Unhedged Commentary: When the Bond Bull Run Ends ... Then What?

  
 Scott Freemon, an investment strategist at SECOR Asset Management.

As yields approach zero, bonds are nearing the end of their 30-year bull run. Against this backdrop, expected returns are down, bond risks are high, and diversification is no longer a free lunch.

The result: Investors must consider new routes to reach their goals.

U.S. yields declined nearly 4 percent in the past ten years — and are down more than 10 percent from their 1980s peak. Near-zero cash yields put pressure on all return-generating investments. Bond investments carry the additional risk of severe negative returns if rates rise sharply. Equities still offer a premium, but that premium has fallen as low yields have increased price-earnings ratios.

With economic stimulus stretched, central banks may find themselves in an increasingly difficult position to combat economic weakness. A natural floor on bond yields at or near zero further reduces the ability of bonds to provide protection in a flight-to-quality equity sell-off.

Stocks and bonds have been negatively correlated since 1998, but this fortunate run is not likely to last. Absent a major recession, we expect stocks and bonds to move in the same direction.

Where does this leave institutional investors, which need to meet often-stringent funding obligations?

It’s possible to increase return targets by loading up on equity beta, but loss tolerances and risk budgets are already stretched. Risk parity represented a huge leap forward in investment thinking, but levered bonds are terrifying in this environment and equal weighting is arbitrary. The rest of the traditional investment universe delivers a return disadvantage to equities, a unique set of risks, and disappointing diversification benefits.

Investors can enhance returns and better manage risks by adding derivative overlays and systematic factor strategies. Both offer enhanced capital efficiency; liquid, scalable return generation; better diversification; and downside risk control.

Using derivative overlays to manage public market beta exposures frees up capital to focus physical assets on high-returning investments, achieves target exposures without using physical allocations, and provides the ability to create asymmetric market risk profiles. By using derivatives to control beta, investors turn market risk into a choice and can manage their portfolios from a risk and factor perspective. Increased oversight of derivatives trading following the financial crisis has created a safer environment to implement derivatives, with much less “career risk” for fiduciaries. Better valuation, clearing, and trading technology have decreased counterparty risk and increased transparency.

Systematic factor strategies can provide investors with risk premia capture (for example, volatility selling), alternative beta replication (trend following), and alpha strategies. These are attractive because they generate liquid, scalable returns with predictable risk and return profiles and strong diversification benefits.

Investors should give equal consideration to beta, hedges, risk premia, alternative betas, and alpha strategies in a single, integrated analysis. These are the building blocks of modern portfolio construction.

Efficient return generation is critical. Leverage, illiquidity, and cash are valuable and need to be used with care. Investors should save their illiquidity budget for high-returning investments like private equity and eliminate anything expected to underperform liquid equities. Similarly, traditional hedge funds should be paired with equity beta overlays, as their returns are too low to justify a stand-alone capital allocation. Most investment-grade fixed-income products can be eliminated because they are lower-yielding and riskier. Similarly, liability-driven investors should consider interest rate overlays.

Efficient risk reduction is equally key. Low-returning allocations should be reserved for true portfolio risk reducers like explicit hedges and hedgelike factor strategies. Trend strategies provide positive convexity and downside hedging without the return drag of option hedges. Options provide reliable downside hedging and can be made affordable by pairing them with income-­generating strategies or spread trades that sell an equivalent amount of optionality. Even if hedging comes at a cost, investors can improve returns if protection supports a more return-­oriented strategy elsewhere.

By expanding the tool kit and adjusting the allocation process, investors can enhance returns, reduce risk, and maintain liquidity and control as they navigate challenging return targets in these difficult times. 

Scott Freemon is an investment strategist at SECOR Asset Management.

Thursday, September 08, 2016

Unhedged Commentary: Finding Value in Value Stocks

   
   Alexander Roepers
By Alexander Roepers


Investment styles tend to move in multiyear cycles. We believe U.S. equity markets recently passed an important inflection point, heralding a rotation back to value investing. This rotation started as a result of stabilizing macro conditions and because many value stocks had become too cheap to ignore, in both absolute and relative terms.

Seven-plus years of zero-interest-rate policy by the Federal Reserve have resulted in a search for yield that has inflated valuations of many financial assets to record levels. After mid-2014, U.S. equity markets experienced an extreme divergence as the collapse in commodity prices and exceptional U.S. dollar strength stoked fears of an industrial recession.

As a result, many investors reduced their exposure to value stocks in favor of perceived safe-haven assets, such as passive large-cap exchange-­traded funds (ETFs), megacap consumer staples and growth stocks. This market dynamic also caused many investors to crowd into momentum stocks, especially the so-called FANG companies (Facebook, Amazon, Netflix and Google), inflating the valuation premium of momentum over value stocks to levels not seen for 35 years — other than the one we saw from mid-1998 to early 2000, during the tech bubble.

In 1998 the equity markets experienced a sharp bifurcation because of macroeconomic disruptions and fears of systemic risk resulting from the Asian financial crisis and the collapse of hedge fund firm Long-Term Capital Management. The ten largest technology stocks had gained an average of 140 percent by the end of 1998, driving the Nasdaq Composite Index and S&P 500 up 40 percent and 29 percent, respectively, that year. For a period of 18 months, investors rotated away from value stocks and into growth and momentum names. However, once the tech bubble burst, in March 2000, investors changed course and began looking for value opportunities. What followed was a seven-­year cycle in which value outperformed growth.

Similar to this historical period, investors initially responded to the global macroeconomic shocks of the past two years by rotating away from value and toward growth and momentum stocks. After a broad-based sell-off in January of this year, which drove valuations of small- and midcap stocks and many value stocks to near-historical lows, investors began to turn their attention to value stocks once again.

This return to value has been facilitated by stabilization of the two macro factors that initially triggered the massive market bifurcation: Commodities have begun to rebound from their oversold conditions, and the U.S. dollar has entered a trading range against other major currencies.

Evidence of this rotation to value can be seen in both U.S. and international equity markets today. Between the market inflection point in February 2016 and mid-­August, the Russell 2000 Value Index outperformed the S&P 500 by nearly 10 percentage points (30.9 percent versus 21.1 percent), while indexes in Australia, Brazil and Russia increased anywhere from 24 to 89 percent in U.S. dollar terms. Recently, the brief panic that followed the Brexit vote in late June, which in our view will have negligible impact on global economic growth, caused a flight to safety stocks and megacaps at the expense of small- and midcap value stocks. Despite this, the rotation back to value has already resumed.

Looking ahead, we see major market-cap-weighted indexes having a modest upward bias because of decent corporate earnings growth, earnings yields of 6 percent (read, a price-earnings ratio of 16) and dividends of 2 percent-plus, on average, in a zero-interest-rate environment. Because of this, these market-cap-weighted indexes are likely to be range-bound in the foreseeable future, as they are dominated by megacap companies with high valuation multiples. Index-tracking funds and ETFs that have benefited from the passive-investing trend are likely to tread water. Conversely, many small- and midcap value stocks have become attractively valued and are poised to outperform as they draw in capital that is leaving the overvalued growth space in search of better risk–reward opportunities. Self-help corporate actions, activism (both constructive and otherwise) and takeovers also will help drive outperformance in the small- and midcap value space.

Given the seven-year cycle of value outperforming growth from 2000 to 2006 and the recent ten-year phase of growth outperforming value stocks, does that mean we are now on track for an extended period of value outperformance? We believe the answer is yes. Markets have now entered a new multiyear cycle, in which active value investing will outperform passive index strategies, with an emphasis on fundamental investing that will help narrow the glaring valuation discrepancies in favor of value stocks.

Alexander Roepers is CIO at Atlantic Investment Management, a New York–based global value-investing firm he founded in 1988.

Monday, July 18, 2016

Unhedged Commentary: Beware the End of Risk On/Risk Off

   
   Dean Curnutt, Macro Risk Advisors
By Dean Curnutt


Despite the historical negative correlation between stock and bond prices, it is time for investors to seriously consider the impact of the conventional risk on/risk off model on their portfolios.

Since the end of the global financial crisis of 2008, the correlation between stock and bond prices has been consistently negative, as the corresponding rally in U.S. Treasuries on days when the Standard & Poor’s 500 stock index has fallen has provided a meaningful shock absorber for diversified portfolios. In fact, since 2010 a 50-50 portfolio of stocks and bonds has produced twice the Sharpe ratio of one invested in stocks alone. Over this period the correlation of returns between the S&P 500 and the iShares 20+ Year Treasury Bond ETF has been -55 percent. If stock and bond prices move inversely, do they not mostly net out, limiting the returns of an equity/bond portfolio over the long run? While their movements are largely offsetting day to day, over a longer horizon both stocks and bonds have experienced dramatic returns since the financial crisis. On a total return basis, the S&P 500 is up 109 percent and the iShares 20+ year Treasury Bond ETF is up 85 percent since 2010.

Stock and bond prices have never expressed such different outlooks for growth dynamics. Work by Greenwich, Connecticut–based asset management firm AQR Capital Management points to the “joint richness” of stock and bond prices. There have certainly been periods in which stock prices were more richly valued. The S&P 500 carried a price-earnings multiple of 30 at the peak of the technology bubble in late 1999. But at that time the nominal ten-year Treasury yield was north of 6 percent with break-even inflation at merely 2 percent, leaving real yields at 4 percent. A forward P/E of 17 and a real yield on the ten-year at zero means that today’s environment consists of valuations that are concomitantly stretched for both stocks and bonds. In my conversations with pension funds, I’m asked consistently to help design hedges for risk parity strategies. There is a great deal of capital committed to strategies that rely on the continuation of a negative correlation between stock and bond prices.

This leads us back to the outlandishly strong risk-adjusted performance of a portfolio that is long both stocks and bonds. As we have seen consistently in markets, winning trades acquire an irresistible track record, providing compelling ammunition for advisers and consultants who lean heavily on back-tested results when making recommendations. Fearing a 2008 style meltdown, investors have been drawn to less risky portfolio constructions, especially when they can deliver similar returns.

The so-called taper tantrum of 2013, now celebrating its third anniversary, is a risk event worth constantly thinking about. The dislocation that beset markets was spawned by a sharp reversal in stock and bond correlations. During that time, instead of rallying on risk-off days, faltering bond prices became the impetus for stocks to fall. While the U.S. Federal Reserve quickly went into damage-control mode, the repricing of risk premia across asset classes was swift. Now, with stock prices just south of an all-time high, expectations of continued earnings growth and a very full market multiple, the Fed is expected to do almost nothing, not just this year but in 2017 as well.

In finance, we are taught that there is no free lunch. Realistically, however, market-pricing regimes that exist for lengthy periods of time are enablers of just this suspect notion. Specifically, the persistent and significant negative correlation between stock and bond prices has served as the most important diversifier post–financial crisis, with tremendous implications for how investors size portfolios. In fact, an entire industry of products has been built on the appeal of back-tests that illustrate how leverage can be utilized to achieve better risk-return outcomes for long stock/long bond portfolios. The impact of utilizing this leverage leans heavily on a continuation of these correlation dynamics. The volatility of a 50-50 portfolio shifts dramatically higher when the correlation moves higher.

The undoing of risk on/risk off could be an absolute disaster for markets. The threat here is especially prominent right now given the joint levitation of both asset classes, likely a central bank policy outcome, and the degree to which the realized diversification has spawned an entire industry of products built on an appealing back-test. Higher inflation, for the very reason investors and central banks cannot see it materialize, stands out as a factor that could sponsor substantial deterioration in both stock and bond prices.

Given the threat posed by the potential that stocks and bonds sell off in unison, investors should develop an understanding of the hedging strategies available to defend against just such an event.

Dean Curnutt is CEO of Macro Risk Advisors, an equity derivatives strategy and execution firm that specializes in translating proprietary market intelligence into actionable trade ideas for institutional clients. The New York–based firm is a registered broker-dealer with FINRA.

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