Author: Marquette Test

What Do Falling Correlations Mean for Active U.S. Equity Managers?

The Implied Correlation Index measures the average correlation of the stocks in the S&P 500 index. When the index is high, individual stocks are more likely to move in tandem with the broad index; when it is low, return dispersion among stocks in the index will be higher.

The Implied Correlation Index measures the average correlation of the stocks in the S&P 500 index. When the index is high, individual stocks are more likely to move in tandem with the broad index; when it is low, return dispersion among stocks in the index will be higher.

Looking at the 1 year chart above, the correlation downtrend is easily visible. With low correlation levels, opportunities should be present for active managers to find alpha and begin outperforming their benchmarks once again. With higher return dispersion, active managers will have an increased opportunity to pick winning stocks. If correlations continue this pattern, it should be easier to identify successful active managers rather than those who have ridden the macro trends of the market in recent years. If nothing else, falling correlations within the index provide an opportunity for active managers to recover from general underperformance versus the benchmark which has plagued them in recent years.

Do Emerging Market Equities Have Further Upside?

Through the end of January, emerging market equities are up 25.4% on a trailing 12-month basis. This asset class has benefitted from several changes to the macro-economic environment: stronger commodity prices, more stable currencies, and a better growth outlook. In addition to these favorable changes, company fundamentals have also shown strong signs of improvement. This week’s chart displays earnings per share (EPS) of the MSCI Emerging Markets Index.

Through the end of January, emerging market equities are up 25.4% on a trailing 12-month basis. This asset class has benefitted from several changes to the macro-economic environment: stronger commodity prices, more stable currencies, and a better growth outlook. In addition to these favorable changes, company fundamentals have also shown strong signs of improvement. This week’s chart displays earnings per share (EPS) of the MSCI Emerging Markets Index.

Since 2013 earnings have been on a sharp downturn but based on forward estimates they appear to have bottomed in 2016. Not surprisingly, much of the initial resurgence has come from the commodities space, however, improved earnings revisions have broadened to other sectors. This is a promising trend for investors and supports further upside potential for this asset class.

Are High Yield Bonds Overvalued Right Now?

High yield bonds enjoyed significant tailwinds in 2016:
During the year, the price of oil stabilized.
U.S. shale oil exploration and production defaults and bankruptcies worked their way through the pipeline and most are now behind us.
Trump’s win, with his promises of tax cuts and infrastructure spending, boosted investor confidence.
OPEC’s production cut agreement further added to the risk-on sentiment.

High yield bonds enjoyed significant tailwinds in 2016:

  • During the year, the price of oil stabilized.
  • U.S. shale oil exploration and production defaults and bankruptcies worked their way through the pipeline and most are now behind us.
  • Trump’s win, with his promises of tax cuts and infrastructure spending, boosted investor confidence.
  • OPEC’s production cut agreement further added to the risk-on sentiment.

All of this fueled a 17.1% return for high yield bonds during 2016, as measured by the Barclays U.S. Corporate High Yield Bond Index. Of course, “bond math” dictates that returns for any sector of the asset class have a ceiling on price escalation, and high yield bonds may be in overvalued territory right now. As we can see in this week’s chart, spreads1  — which are a primary valuation metric for bonds — are tight at the moment, at 388 basis points on January 31 for the Barclays U.S. Corporate High Yield Bond Index compared with its ten-year average of 606 basis points. In other words, current high yield bond spreads are more than 200 basis points tighter than long-term average spreads. If we exclude the financial crisis years of 2008 and 2009, the long-term average spread is 508 basis points and current spreads are still considered tight. Current spreads are about as tight as they were prior to the shale oil crisis of 2014-2015.

High yield spreads typically compress to the point when a market correction occurs. This market correction typically features spread widening. Because of such tight spreads at the moment, as well as other fundamentals that we track such as aggressive use of proceeds and aggressive lower-quality issuance, spreads are more likely to widen than further tighten. As such, we recommend that clients reallocate to policy weights and maintain a cautious and conservative outlook for high yield bond allocations.

___________________
1 Defined as the excess yield above U.S. Treasury bond yields

Are Quant Strategies Poised to Replace Fundamental Managers?

As 2016 performance trickled in, the depth and prevalence of underperformance became very apparent. What made 2016 such a particularly difficult year for active management? Many have cited the tumultuous events throughout the year ranging from the market dip and subsequent recovery in the first quarter, to the Brexit, to the unexpected Trump victory. Rapidly reacting and adapting to these market changes – let alone capturing any alpha – was incredibly challenging.

As 2016 performance trickled in, the depth and prevalence of underperformance became very apparent. What made 2016 such a particularly difficult year for active management? Many have cited the tumultuous events throughout the year ranging from the market dip and subsequent recovery in the first quarter, to the Brexit, to the unexpected Trump victory. Rapidly reacting and adapting to these market changes — let alone capturing any alpha — was incredibly challenging.

Notably, quantitative strategies seemed to have an easier time reacting to these events than fundamental strategies. Quantitative, or “quant,” strategies rely heavily on statistical and mathematical screens and indicators which largely remove human emotion and judgment from the equation. These models arguably enabled portfolios to recognize the surprise market events of 2016 and adapt much more quickly than fundamental strategies. However, while quant strategies largely proved successful relative to their fundamental counterparts in 2016 during an array of smaller disruptive events, this pattern is not proven to hold during severe inflection points.

Will Investors Continue to Move Away from Active U.S. Equity Strategies?

This week’s chart shows asset flows between active and passively managed mutual funds and exchange traded funds (ETFs) in U.S. equities. Over the last eleven calendar years, active strategies experienced cumulative outflows totaling $864 billion, while passive strategies saw inflows of nearly $460 billion.

This week’s chart shows asset flows between active and passively managed mutual funds and exchange traded funds (ETFs) in U.S. equities. Over the last eleven calendar years, active strategies experienced cumulative outflows totaling $864 billion, while passive strategies saw inflows of nearly $460 billion.

Strong passive flows such as this can potentially have a negative effect on active performance since stocks are less able to differentiate themselves on fundamental factors. When passive strategies receive significant inflows, all stocks in an index are purchased and receive price support. This can have a material impact on stocks with limited trading volume, thus this is more of an issue for small-cap versus mid or large-cap. Within small-cap, passive inflows in 2016 totaled $7.6 billion while active outflows totaled $18.5 billion. The Russell 2000 Value posted the strongest return within the nine U.S. equity style boxes during 2016, while active strategy outperformance in small-cap value was especially challenged relative to the other style boxes.

With passive U.S. equity indices ranking in the top half or better of their respective peer groups in recent years, active strategies have largely lagged behind their benchmarks. This performance lag is a primary reason why asset flows have shifted to passive strategies. Since a passive strategy essentially owns the market, passive allocations have fully participated in the current bull market, while active strategy performance depends on how a particular fund’s bets fared relative to its benchmark. Passive investing represents a low-cost means of gaining exposure to an asset class and fees are often a small fraction of the fees paid for active management. With valuations at or close to all-time highs, active manager performance will be closely monitored in 2017 to see if their higher fees are justified in this current market environment.

Should Investors Allocate to EMD in 2017?

Recent events have strengthened the case for Emerging Markets Debt (EMD). Our chart of the week shows how yields for local and hard currency strategies are above their historical averages and are an attractive opportunity as we begin 2017.

Recent events have strengthened the case for Emerging Markets Debt (EMD). Our chart of the week shows how yields for local and hard currency strategies are above their historical averages and are an attractive opportunity as we begin 2017.

The European Central Bank extended stimulus by nine months, albeit at €60 billion per month instead of the original €80 billion per month. Trump’s trade policy proposal is largely isolated to China, and his immigration policy may have a positive effect on Mexico given that its consumer pool and labor force may grow as a result. Lastly, the price of oil is on the rise with the recent OPEC deal, which is a positive for EM oil exporters. All of these facts support an allocation to EMD.

If Trump’s infrastructure policy is enacted we would expect commodity prices to rise, which would be a tailwind for EM commodity exporters. If Trump’s trade policy is adopted, it should be a headwind for EM manufacturers. But overall, EMD fundamentals are attractive. Current accounts of EM countries are stronger and leverage is still low relative to developed market countries. Spreads are at wide levels and yields are high, which provide a cushion for any downside. In total, EMD offers diversification, yield, and upside potential and should contribute to positive returns for investors in 2017.

What Does the Buffett Indicator Tell Us About U.S. Equity Valuations?

As markets continue to reach new all-time highs many investors are wondering how much more runway is left for the current 8-year bull market. While different valuation metrics will tell different stories, it can be helpful to look at what Warren Buffett has dubbed the single best measure of long-term market valuations.

For this week’s chart of the week, we take a look at the “Buffett Indicator” which consists of the Wilshire 5000 index market cap divided by the quarterly nominal GDP of the U.S. economy. As of the third quarter, the reading stood at 121%, just below its two decade high and 45-year two standard deviation average. These readings would suggest that the market is overbought. However, there is no perfect market indicator, so while the Buffett Indicator can be used as a sign of caution to investors who are considering committing further funds to U.S. equities, it should not be relied upon as an exclusive predictor of future market returns. Although the Buffett Indicator suggests that valuation levels are high, positive earnings growth began to emerge in late 2016 and could provide further support for current valuations if companies can deliver on profit projections. These statistics will be watched closely as the year unfolds to gauge the future direction of the U.S. equity market.

Hedge Fund Assets Under Management Continue To March Higher

As the investment community continues to debate the role of hedge funds in the future, one thing is for certain, assets continue to flow into this much debated space. 

As the investment community continues to debate the role of hedge funds in the future, one thing is for certain, assets continue to flow into this much debated space.

The above chart goes back ten years to show the overall growth of assets in hedge funds. As it would be expected, 2008 saw overall assets under management decline following a difficult market environment. Since that timeframe assets have steadily increased year over year, despite high fees and at times disappointing performance. 2016 was no different with a difficult first half as overall returns underperformed the broader market indices, assets still flowed into this space. Hedge funds will still be a sought after asset class for institutional investors as they provide diversification, bond-like volatility, and low correlation to traditional long-only assets. To remain competitive, hedge funds will have to cut management and performance fees to remain attractive to the largest capital allocators.

2016 Asset Allocation Winners and Losers

January is a time to reflect on the past year and assess what went right and what went wrong, and asset allocation is no different in this regard. Elevated valuations at the start of 2016 did not hold back U.S. equities as they climbed to record highs; small caps were the outright winner with a 21% return. These smaller cap companies received a post-election boost as they were expected to be less affected by the strengthening dollar and potential trade policies enacted by Trump, since they do not typically conduct much international business. The knock-on benefits of a potential lower corporate tax rate also helped propel small-cap equities higher after the election.

January is a time to reflect on the past year and assess what went right and what went wrong, and asset allocation is no different in this regard. Elevated valuations at the start of 2016 did not hold back U.S. equities as they climbed to record highs; small-caps were the outright winner with a 21% return. These smaller-cap companies received a post-election boost as they were expected to be less affected by the strengthening dollar and potential trade policies enacted by Trump, since they do not typically conduct much international business. The knock-on benefits of a potential lower corporate tax rate also helped propel small-cap equities higher after the election.

Internationally, slowing growth concerns were a determinant of performance. The “anti-establishment” sentiment seen in Europe was a major source of uncertainty. Emerging markets were the most appealing in terms of relative valuations, which helped them deliver double-digit returns after three consecutive negative years.

Lastly, fixed income was led by high yield bonds which rallied back from an end-of-year dip in 2015, with lower quality issues leading the way. Long duration bonds were also a top performer within fixed income, as were bank loans. After the Trump victory revived inflation expectations, TIPS became a topic of discussion. Realistically, as policies will take time to implement, inflation will manifest slowly and will be only one of a few indicators to monitor.

Of course, 2016 is behind us and investors are at this point more interested in what the markets will bring us in 2017. While predicting market winners and losers each year is a difficult exercise, it is safe to say that we will not see a repeat of 2016 asset class performance, and maintaining a diversified portfolio with disciplined rebalancing will help to mitigate risk no matter what happens across the global markets.

Are Active U.S. Equity Managers Poised for a Rebound Heading into 2017?

This week’s chart of the week highlights the recent change in correlation between the stocks that comprise the S&P 500 as measured by the CBOE S&P 500 Implied Correlation Index. On November 18, 2016 correlation among stocks fell to a post-recessionary low of 26.5 compared to an average reading of 59.8.

This week’s chart of the week highlights the recent change in correlation between the stocks that comprise the S&P 500 as measured by the CBOE S&P 500 Implied Correlation Index. On November 18, 2016 correlation among stocks fell to a post-recessionary low of 26.5 compared to an average reading of 59.8.1 A lower measure signals to investors that sectors and styles in the S&P 500 have started to move independently after years of volatility and tighter correlation. This environment should allow active managers to generate alpha, as stock selection plays a key role in outperformance. As this trend continues, managers can focus on bottom-up fundamentals (i.e., company valuations) and less on macro-economic events that could cause dispersion within the asset class. For active managers, dispersion is critical because it allows them more opportunity to select winners and losers and thus outperform the indices against which they are measured. For investors with large allocations to actively managed U.S. equity portfolios, this is good news heading into the New Year.

 

1The Implied Correlation Index measures correlation on a scale of -100 to 100, rather than the mathematical scale which is between -1 and 1.