Unhedged Commentary

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.

Tuesday, June 14, 2016

Unhedged Commentary: The Rise of Fundamental Insensitivity

   
      Oliver Marti, Columbus Circle Investors

By Oliver Marti

Over my 25 years of equity research and investing, including the past 15 years managing a health care long-short strategy, I’ve witnessed many changes in what drives stock prices — including the influence of monetary policy decisions, the increased speed and amount of information (or misinformation) distribution and the significant decline in order size. But I am now observing a change that is more significant than any I’ve previously seen. The massive growth in exchange-traded funds is changing how stocks trade and are priced, bringing new challenges as well as opportunities for investors.

Numerous statistics suggest the number of U.S.-listed ETFs has increased from 100 in 2000 to more than 1,500 today, with assets under management growing from less than $100 billion to roughly $2 trillion over the same period. The Investment Company Institute, a mutual fund trade association, reports that since 2008, $410 billion has flowed out of mutual funds, while at the same time, $1 trillion has gone into ETFs. Based on the growth in ETFs, it is estimated that on average the percentage of U.S. trading volume coming from ETFs has gone from virtually nothing in 2000 to approximately 25 percent in 2016.

This growth is having a profound effect on how stocks are priced and has implications beyond the usual debate about passive versus active management. ETF growth is driving a de-emphasis on investing in individual stocks based on their merits and a move toward sector bets and factor model investing, grouping stocks of the same ilk in one basket. Many have heard the term smart beta, but the term I think best fits this fast-growing trend is fundamental insensitivity.

Investing in ETFs can allow investors, especially individual investors, to build diverse portfolios, get exposure to specific sectors, avoid company-specific risk, hedge and pay lower fees — all positive attributes. However, as ETF-based strategies have exploded in size, an unintended consequence has been an increase in periods of erratic price movements in stocks sharing similar characteristics. (I also believe the growth in quantitative funds may be having an equally large impact, but data in this area is harder to come by.)

Prices are increasingly affected by demand and supply for an asset class, style or sector, instead of being driven by individual business fundamentals. Investor demand to move in or out of certain sectors or factors can drive a particular asset, stock or sector meaningfully away from its intrinsic value, often extremely rapidly. This effect is elevated during periods of rising uncertainty and higher volatility, and the impact tends to be greatest on lower-liquidity and smaller market-cap names.

For fundamental investors, it is now more difficult to determine what is in fact discounted into a company’s valuation. How much of a stock’s move is fundamentally driven? How much is positioning? With the increase in ETFs, along with quant funds, it seems more and more that a significant portion of a company’s price movement is driven by investors simply getting long or short exposure to a trend, factor or sector that is in or out of favor. Stocks of the same ilk get grouped together with little differentiation between fundamentally stronger and weaker companies.

My team and I have seen the general phenomenon of ETF growth play out specifically in the health care sector. A Bank of America Merrill Lynch analysis utilizing data from research firm EPFR Global shows assets in health care/biotechnology ETFs have greatly surpassed assets in health care/biotech mutual funds since 2013. In fact, the analysis suggests that today, of the total U.S. assets in health care/biotech, only a third is actively managed, with two thirds passively managed. What that means is that correlations rise, and over shorter periods of time, nonfundamental factors can drive stock performance, both long and short.

We believe these changing dynamics have had a significant impact on the stock prices of many companies in the health care industry since July 2015. Health care witnessed a sudden rotation out of favor, with biotechnology companies hit the hardest as evidenced by a first-quarter 2016 decline for the Nasdaq Biotechnology Index that was the worst on record.

While it is fair to conclude that there is increased uncertainty around health care policy and drug pricing, the uniform and rapid decline in stock prices across biotech seems to be a symptom of the changing ETF marketplace. Data provided by Credit Suisse’s Quant & Equity Trading Strategy team regarding trading in the SPDR S&P Biotech ETF (XBI) suggests that this single ETF at times contributes an estimated 30 percent or more of the average daily volume in many of the stocks it holds. Other ETFs holding those same stocks drive that figure higher, demonstrating how ETF trading can have an outsize impact on volume and therefore on stock price movements.

An uncoupling of stocks from underlying value has and will at times make fundamental long-short investing more difficult during short-term periods, since correct assessments of stronger and weaker companies are less likely to be rewarded in near-term price movements. However, we still believe that companies ultimately will be priced on intrinsic value, and therefore the erratic pricing we are seeing is creating more situations where companies are materially under- or overvalued.

This increase in the number of significantly mispriced stocks should mean higher long-term returns for managers and investors who can identify these situations and have the patience to stay the course. In our sector, health care, we believe the market has overreacted to potential changes in health care policy, which is creating excellent investment opportunities.

Oliver Marti is Senior Managing Director at Columbus Circle Investors and manages the CCI Healthcare equity long-short team.

Wednesday, May 11, 2016

Unhedged Commentary: The $3 Trillion Question

   
   

By Mark Anson and Ryan Driscoll

The growth of the hedge fund industry over the past decade has been tremendous, with more and more institutional and retail investors allocating capital to investment strategies that fall outside the boundaries of traditional stock and bond funds. The hedge fund industry, which has gone from managing approximately $240 billion in 2000 to $3.2 trillion at the end of 2015, has grown by 19 percent annually, on average. It is only natural to question whether there is sufficient capacity for this amount of capital to be absorbed and productively invested in these alternative-investment strategies.

Perhaps it is worthwhile to take a step back and observe what propelled the hedge fund growth story. Partly, it was the advent of so-called endowment-style investing. A key principle of endowment investing is to expand the efficient frontier of portfolio construction into alternative assets, where investment strategies are less constrained and have the opportunity to add excess returns while providing additional portfolio diversification. The growth of hedge fund assets parallels the popularity of other alternative-asset classes, such as private equity and real assets.

Another reason for hedge fund growth traces back to the popping of the tech bubble. Once the fantasy of technology stocks taking over the world faded and a global recession ensued, equity markets around the world experienced double-digit declines for three straight years, from 2000 to 2002.

During this time period hedge funds lived up to their name: Many hedged their portfolios and generated positive returns. The Barclay Hedge Fund Index recorded gains of 12.2 percent, 6.8 percent and 1.4 percent during 2000, 2001, and 2002, respectively. Not only did hedge funds produce positive returns during this time, they did so while taking less risk than that generated by the equity markets.

More accurately, using Sharpe ratios, we found that hedge funds far outperformed the global equity markets during 2000–’02. We use risk-adjusted returns because investors often overlook the fact that hedge funds generate their returns with a much more risk-controlled process than the broad financial markets. Specifically, from 2000 through 2002 hedge funds produced large, positive Sharpe ratios compared with the negative returns generated by the stock market. This performance helped to fuel the demand for hedge funds as an important component of a diversified portfolio.

However, since the Great Recession hedge funds have not outperformed the stock market. Again using Sharpe ratios, we found that the risk-adjusted returns of hedge funds are on par with those of the S&P 500 index. This might lead investors to conclude that the hedge fund industry has become capacity-­constrained.

The recent performance of hedge funds has ratcheted up the debate about whether these funds deserve their fees. With such a long growth trajectory for hedge fund assets, it would not be surprising to discover that exposure to beta has crept up in hedge fund portfolios over the years.

Over time, as any active manager accumulates assets, it will become capacity-constrained in its alpha generation; it simply cannot put as much capital to work in its active strategy. As a result, more of an active manager’s portfolio may have to be put to work through beta trades —investments that accumulate more market exposure than genuine alpha.

Surprisingly, this does not seem to be the case with hedge funds. We reviewed several hedge fund strategies, and we did not observe any marketable increase in beta exposure over the past 15 years. Although the amount of beta exposure does fluctuate, there has been no discernable uptick since 2000. This provides some comfort that the hedge fund industry is not capacity-constrained.

So where does this leave us? Unfortunately, we are unable to resolve the dispute over whether hedge funds add sufficient value for the fees they charge. On the one hand, it appears that hedge fund managers are not capacity-­constrained — the amount of beta in their portfolios has not crept upward over time. On the other hand, the risk-adjusted performance of hedge funds since the Great Recession does not seem to warrant the standard 2 percent management fee and 20 percent performance fee structure that managers frequently demand. This means that the hedge fund industry is best approached with a discerning eye to select those managers who have a competitive edge. Alpha exists, but can it be captured in both a cost-effective and a risk-efficient manner? The debate continues. a

Mark Anson is chief investment officer and Ryan Driscoll is director of trading at Wilton, Connecticut–based Commonfund.

Wednesday, March 16, 2016

Unhedged Commentary: Giving European Credit its Due

   
   Stuart Fiertz

With continued market volatility in early 2016, the collapse in oil prices, shocking acts of terrorism and waves of migrants seeking refuge from war, at Cheyne we believe Europe deserves more credit - literally. The anticipation of a flood of credit opportunities in the euro zone has existed for several years but proved fleeting. However, we think the time is ripe for compelling and scalable opportunities in alternative credit within Europe because of the combination of well-meaning but poorly designed regulatory reforms and the fact that efforts to address the looming need to shrink the banking system have only just begun.

To profit from the recent dislocation and increase allocations to Europe, investors will need to accept that we have reached the level of political and economic distress necessary to trigger effective policy responses. We think we have: European Central Bank president Mario Draghi has dusted off the quantitative easing playbook, U.K. Prime Minister David Cameron appears to be getting closer to securing sufficient concessions from the European Union to neutralize the risk of Brexit, and the EU is building fences on its external borders to stem the flow of migrants.

The global financial crisis highlighted that the European banking system was far too large relative to the size of the European economy. This means that European banks remain overly reliant on wholesale funding and are too big to either be left to fail or bailed out again. Regulators have recognized this and responded with measures to force banks to shrink their balance sheets, including increased capital requirements and explicit leverage limits.

Alternative credit has the opportunity to offset the withdrawal of liquidity that will result from shrinking European bank balance sheets. Consider that the total assets of U.S. banks are some $14 trillion, whereas the assets of European banks total $41 trillion although the underlying economies are approximately the same size.

The transition toward alternative credit is now being supported by the EU, which has gone from vilifying nonbank sources of credit to actively promoting them. Furthermore, the European distressed-­corporate-credit cycle is shifting toward opportunity. Postcrisis, many investors thought there was going to be a fire sale of European corporate loans. This flood of sales didn't occur, as European banks proved more willing to sell real estate assets than corporate loans. One of the motivations was political pressure to safeguard jobs and avoid putting companies into the hands of private equity, which would look to rationalize operations. Another factor was the surprising growth in the European high-yield market, which allowed the orderly refinancing of most of the largest and most leveraged companies.

It is also evident that European banks were not in a position to absorb the hit to their capital that would have been necessary to mark the corporate loans down to their clearing level. While still undercapitalized, European banks are today in a much improved position to sell down their corporate exposure, which will now begin to increase the supply of distressed corporate opportunities.

In the wake of the crisis, the impact that unemployment rates had on forcing real estate borrowers into receivership was muted. Banks were therefore in a much better position to sharply reduce their risk appetite for real estate loans as the crisis unfolded.

The most attractive opportunities can be found where the new regulatory capital regimes are most punitive and where the local regulator has a particularly negative bias. Bank loans to fund new construction, for example, are more readily available than loans for refurbishment. The opportunity to make this type of loan is underlined by the fact that the availability of credit in European real estate has been severely constrained since as far back as 2007, leaving a generous supply of assets in need of capital expenditures. What's more, there are an estimated €745 billion ($826 billion) of loans that will need to be refinanced over the next three years. It is estimated that European banks still need to work out some €333 billion of noncore real estate loans.

The total of nonperforming corporate loans that are likely to be sold by European banks now dwarfs the remaining noncore real estate on bank balance sheets. It is an indication of how far attitudes toward alternative credit have changed that the Italian government recently chose to securitize €350 billion of nonperforming corporate loans rather than sell them outright. a

Stuart Fiertz is president of London-­based Cheyne Capital Management (UK) and chair of the Alternative Credit Council of AIMA. This article is based on his findings from a recently published white paper.

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