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.

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