Author: Marquette Test

Fundamental vs. Quantitative Analysis

Most investors likely understand what is known as “fundamental” investment analysis: analysts assess a company’s health based on revenue, earnings, cash flow, and other financial and economic indicators. An alternative method of identifying attractive investments is “quantitative” investment analysis, and this approach has soared in popularity over the past few decades. Quantitative analysis features complex mathematical models which incorporate statistical and economic variables including valuation ratios, risk measurements, and trading behaviors of a stock, though the possibilities for variables are nearly endless. The advent of social media has even made it possible to include behavioral variables that adjust for investor sentiment.

Most investors likely understand what is known as “fundamental” investment analysis: analysts assess a company’s health based on revenue, earnings, cash flow, and other financial and economic indicators. An alternative method of identifying attractive investments is “quantitative” investment analysis, and this approach has soared in popularity over the past few decades. Quantitative analysis features complex mathematical models which incorporate statistical and economic variables including valuation ratios, risk measurements, and trading behaviors of a stock, though the possibilities for variables are nearly endless. The advent of social media has even made it possible to include behavioral variables that adjust for investor sentiment.

As charted above, the average “quant” fund has outperformed the average fundamental fund on a trailing 1-, 3-, 5-, and 7-year gross-of-fee basis within the eVestment universe, a database used to track investment products. This recent outperformance is in stark contrast to the same trailing numbers just seven years prior (2009), shortly after the Financial Crisis. Critics argue that because many models use similar inputs, there is a large overlap in holdings amongst quant managers and that during a negative inflection point in the market, many portfolios are trying to dump the same stocks; the trailing performance as of 3/31/2009 certainly supports this argument. However, quant managers that survived the financial crisis argue that they have since built more adaptable models. Additionally, the amount of data readily harvested and available has grown exponentially over the past decade, which could help quantitative models become more robust.

What lies ahead for quant funds if the markets are hit swiftly with a large downturn? If the Brexit is any indication, albeit a very mild one, quant managers may have in fact prepared themselves for such a situation. For the second quarter of this year, quant managers were flat with or slightly below fundamental managers on a gross-of-fee basis. Considering quant funds typically charge much lower fees than fundamental funds, if they are able to adapt in a swiftly changing market environment, then they may prove useful as a low-cost option within a portfolio.

Equity Returns Post Brexit

The United Kingdom’s (UK) vote to leave the European Union on June 23 was an unprecedented event that impacted markets across around the world. While this exit won’t actually take place for another two years, equities sold off in a knee-jerk fashion as investors feared the ramifications on the global economy. Due to the heavy exposure to Europe, non-U.S. developed markets suffered the most, losing nearly 10% before rebounding.

The United Kingdom’s vote to leave the European Union on June 23rd was an unprecedented event that impacted markets around the world. While this exit won’t actually take place for another two years, equities sold off in a knee-jerk fashion as investors feared the ramifications on the global economy. Due to the heavy exposure to Europe, non-U.S. developed markets suffered the most, losing nearly 10% before rebounding.

With the U.S. viewed as a safe haven, domestic equities have fared relatively well in the Brexit aftermath. The U.S. dollar appreciated following the decision while the British pound slumped to a 30 year low against the greenback. Emerging market (EM) currencies have also depreciated against the dollar however EM equities have been one of the stronger performers. This asset class has benefitted from the U.S. Federal Reserve indicating it will not make any significant interest rate movements due to the risk the Brexit poses to the economy. Only a few days after the UK vote, EM equities rallied for its biggest weekly gain since March. While the Brexit will undoubtedly have long-term ramifications, many of which are currently unclear, equity markets have rebounded from the initial sell-off.

Predicting the Brexit Vote

Today – Thursday, June 23rd – is the long awaited date of the “Brexit” vote in which the United Kingdom will choose to with draw from or remain in the European Union. In the weeks leading up to today’s referendum, many polls indicated a very slim margin between the “remain” and “leave” votes, thus creating another layer of uncertainty within the financial markets.

Today – Thursday, June 23rd – is the long-awaited date of the “Brexit” vote in which the United Kingdom will choose to withdraw from or remain in the European Union. In the weeks leading up to today’s referendum, many polls indicated a very slim margin between the “remain” and “leave” votes, thus creating another layer of uncertainty within the financial markets.

However, recent market movements indicate that investors are betting on the “remain” campaign, led by Prime Minister David Cameron. As shown in this week’s chart, the pound/dollar exchange rate (blue line) was pushed toward a five-month high earlier this week. In fact, the sterling leapt the most since the Global Financial Crisis of 2008, and is already trading at levels that economists predicted it would reach after the referendum on Thursday. Additionally, European stocks reached their biggest three-day gain in almost 10 months erasing the UK’s benchmark index’s monthly decline.

Though the results of the Brexit vote will not be known until after markets close today, the above data combined with early market movements on Thursday indicate that the Brexit vote will fail and England will remain in the European Union. Should that expected result change, we can expect heightened volatility in the short term, with longer-term impacts on financial markets less clear at this point. As always, we will keep our clients abreast of market developments and potential portfolio ramifications.

Time to Buy Biotech?

The biotech industry has taken a beating and dropped about 35% since its peak last summer as many investors have come to regard it as too speculative and risky. However, a contrarian view indicates that the Nasdaq Biotech Index is trading at a discount relative to its historical price-to-earnings and price-to-book ratios, and now may be an attractive buying opportunity.

The biotech industry has taken a beating and dropped about 35% since its peak last summer as many investors have come to regard it as too speculative and risky. However, a contrarian view indicates that the Nasdaq Biotech Index is trading at a discount relative to its historical price-to-earnings and price-to-book ratios, and now may be an attractive buying opportunity.

Charted, we see the recent dip in Nasdaq-listed biotechs, though earnings have recently recovered and book value has steadily grown since the beginning of the biotech rally. The majority of the book value growth has been in intangible assets indicating that companies are expanding their patent arsenal. This buildup of intellectual property is a positive sign given the increased expenditures in research & development. Though only a few of these advancements will come to fruition in the marketplace, the thought is that those that make it will pay off handsomely for investors.

While fundamentals appear steady, investor skepticism is beginning to impact fundraising. Only $483 million has been raised via 8 biotech IPOs through May of 2016 while over $2 billion was raised via 17 IPOs during the same time period in 2015. Larger and more financially stable firms, such as Celgene, have capitalized on lower valuations through share buybacks. Smaller firms seeking cash to develop their pipelines, however, may begin to suffer if the sentiment of investors does not change. For now, the current ratio of this index has remained stable, indicating that there is no near-term liquidity problem for the industry.

Ultimately, the industry retains great potential. Drugs are shifting from blanket treatments that may only be partially effective for a mass population to specialized approaches for smaller populations with significantly increased efficacy. This increases revenue opportunities as a few specialized treatments are now regularly combined for a more potent approach. In an age when manipulating a genome is commonplace, revenue and earnings growth potential is seemingly unbounded. Though many of these technologies may prove unviable, investor sentiment for the industry may be overly negative given current valuations, stable fundamentals, and the sea of promising advancements available in the field.

A Bifurcation in High Yield Defaults

The price of oil recently rose over $50 per barrel following a dip near $30 only a few months ago. Despite this price recovery, many high yield energy issuers are still finding it difficult to make their debt payments, and default activity surged in May.

The price of oil recently rose over $50 per barrel following a dip near $30 only a few months ago. Despite this price recovery, many high yield energy issuers are still finding it difficult to make their debt payments, and default activity surged in May. These defaults are defined as missed coupon payments, missed principal payments, bankruptcy filings, or distressed exchanges. Notable May defaults include Linn Energy, SandRidge Energy, Midstates Petroleum, Breitburn Energy Partners, and Penn Virginia.

The default rate of the overall high yield index is now 5.2%, as shown by the blue line in this week’s chart. The default rate has recently risen due to more defaults in the high yield energy and metals/mining sectors. Defaults of issuers in that space now stand at 17.8%, as shown in the red line. Meanwhile, excluding energy and metals/mining, the default rate is at pre- and post-crisis lows, at 1.7% as shown in the green line. This bifurcation means that while the energy and metals/mining sectors have suffered from low oil and metals prices, the rest of the economy — healthcare, technology, financials, etc. — have performed as well as ever, at least in terms of how defaults can reflect performance.

The 5.2% overall high yield default rate and the 17.8% high yield energy and metals/mining issuer default rate confirm our previous paper about expected defaults for the year. Based on March-end spreads as a measure of the market’s expectation of defaults, the market was implying a default rate of 4.77%. The range we provided was 4% for the overall high yield default rate if the high yield energy and metals/mining issuer default rate reaches 10%, to 6.2% for the overall high yield default rate if the high yield energy and metals/mining issuer default rate reaches 30%, to 8.4% for the overall high yield default rate if the high yield energy and metals/mining issuer default rate reaches 50%. With the steady rise in the price of oil, we would be surprised to see the high yield energy and metals/mining issuer default rate reach as high as 50%, which should eliminate the worst case scenario for high yield investors. Of course, capital markets are dynamic and can change unpredictably, so we will continue to monitor this trend.

What Should We Expect From an Oil Rebound?

Over the past 18 months oil has been a significant drag on global financial markets. While oil producing countries have obviously been hit the hardest, the rest of the world has also struggled. But recently there’s been a mild resurgence in oil, with the WTI index now near $50 per barrel.

Over the past 18 months, oil has been a significant drag on global financial markets. While oil producing countries have obviously been hit the hardest, the rest of the world has also struggled. But recently there’s been a mild resurgence in oil, with the WTI index now near $50 per barrel. This is still nowhere near its previous levels of over $100, but it is a significant increase from the low of about $26 seen earlier this year. This Chart of the Week examines what this means for different parts of the world by looking at the daily correlations between oil and MSCI countries’ indices over the past 18 months.

Not surprisingly, emerging markets, along with Canada, have the highest correlations due to their heavy dependence on oil exports. They’ve also had the worst performance over the past few years but stand to gain the most from rising oil prices. Developed markets though also have high correlations and even in the U.S. and Japan, which have the least significant correlations, oil is still a major factor. These correlations won’t necessarily hold up going forward, but the trend suggests that if oil continues its slow recovery financial markets will benefit across the board. While other issues may affect this recovery, such as a “Brexit” or Japan’s deflationary pressures, overall rising oil prices should be a boost to the global economy.

Can Brazil (Pole) Vault Its Way Out of a Floundering Economy?

While the Olympic Games certainly impact a host country’s balance sheet, what about their impact on the local stock market? What do local businesses have to gain from the massive influx of tourism spending and how can we expect this to impact Brazil for the coming games?

While the Olympic Games certainly impact a host country’s balance sheet, what about their impact on the local stock market? What do local businesses have to gain from the massive influx of tourism spending and how can we expect this to impact Brazil for the coming games?

Charted above is the calendar year performance of a hosting country’s local stock market index for the year in which it hosted the summer games. Two outliers are noticeably apparent: South Korea during its dramatic economic growth period and China during the recent financial crisis. Omitting these given their extenuating economic circumstances, the average performance at year-end is about +12%. While this sample size is much too small from which conclusions can be derived, there may be validity to the thought that the short-term net economic impact of hosting the Olympics is a positive one.

Brazil is expecting an influx of 500,000 tourists for the games, and oftentimes a tourist visiting specifically for the Olympics is likely to spend more money than the typical tourist. For example, in London during the 2012 games, an Olympic-specific tourist spent £1,290 vs. £650 of the commonplace tourist. With Brazil in its worst recession since the 1930s, the country needs as much of the Olympic stimulus that it can get. Unfortunately, Brazil is facing a staggering number of hurdles blocking it from attracting the tourists it desires. Bad press surrounding the mistreatment of local citizens, the Zika virus hotbed, and an unfinished Olympic infrastructure may keep the big spenders away. Managing a successful experience for the athletes and at-home viewers, let alone extracting economic benefit from tourists, may require too much of a Herculean effort for the struggling country. Either way, though, the short-term stock returns from Brazil will reflect the success – or lack thereof – of the country’s Olympic hosting prowess.

Are Real Estate Returns Headed for a Correction?

Core real estate investments have flourished since the financial crisis, with the NCREIF Property Index (“NPI”) returning 13.3% in 2015, its sixth consecutive yearly gain after the real estate recovery began in 2010. Not surprisingly, investors are now wondering if this run can continue, or if it is time to pull back on their allocations to real estate.


Core real estate investments have flourished since the financial crisis, with the NCREIF Property Index1 (“NPI”) returning 13.3% in 2015, its sixth consecutive yearly gain after the real estate recovery began in 2010. Not surprisingly, investors are now wondering if this run can continue, or if it is time to pull back on their allocations to real estate. In this week’s chart, we look at the historical total returns of the NPI going back to 19782 broken out by appreciation and income. The NPI was first launched in 1978, and since then, real estate cycles have historically lasted more than 10 years. The first cycle featured 13 years of positive total returns followed by a negative 5.6% return in 1991 as a result of severe oversupply in the market. These negative returns only lasted two years before again turning positive from 1993 until 2008, when returns flipped negative due to the global financial crises.

Since the Global Financial Crisis, core real estate has made a robust recovery, generating double-digit returns over the past six years, but the real question is whether or not such impressive returns can continue. On one hand, supply for most commercial real estate sectors is still below their pre-recession averages, cap rates may compress further given their spread to Treasuries, income levels are favorable, leverage is manageable, and debt maturity profiles are appropriately structured. On the other hand, valuation levels are high as a result of price appreciation, and significant capital has flowed into the asset class. Ultimately, we do not believe that real estate returns are poised for a correction, but anticipate they will retreat from the double-digit territory we have seen over the past six years to a more realistic mid- to high-single-digit range.

 

1The NCREIF Property Index measures the return of individual commercial real estate properties that are acquired in the private market for investment purposes only.

2Inception year of the NCREIF Property Index was 1978

UK: Should I Stay or Should I Go?

This week’s chart looks at polling information for the UK Referendum scheduled on June 23rd. On that day voters will decide whether or not to remain in the European Union.

This week’s chart looks at polling information for the UK Referendum scheduled on June 23rd. On that day voters will decide whether or not to remain in the European Union. Taking inspiration from last year’s “Grexit”, the market has appropriately named this potential event as the “Brexit.” The chart shows a Bloomberg composite indicator which takes an average of polling data from several surveys. The most recent results report 41% in favor of remaining, 40% in favor of leaving, and 19% undecided, suggesting a very close vote. The odds-makers, however, place the chance of the “Brexit” around 35%. In terms of economic consequences, it is hard to predict exactly what would happen should the “Brexit” occur, but in general, investors can expect to see a weaker pound, reduced business investment, and weaker economic growth with some spillover effects to the Eurozone. This is an event worth watching as it will likely have some influence on short-term market performance leading into the summer.

A Continued Shift from Active to Passive in U.S. Equities

This week’s Chart of the Week examines the ongoing shift from actively managed to passively managed U.S. equity allocations. While active investing has historically been the predominant form of portfolio management, investors are increasingly recognizing that passive strategies are an efficient manner of capturing market beta.

This week’s chart examines the ongoing shift from actively managed to passively managed U.S. equity allocations. While active investing has historically been the predominant form of portfolio management, investors are increasingly recognizing that passive strategies are an efficient manner of capturing market beta. Within U.S. equities, the theme of fund flows migrating from active to passive has been dramatic over the past several years. Since 2007, passive strategies benefited from consistent fund inflows while active strategies continually dealt with fund outflows. With the exception of 2013, actively managed U.S. equity strategies saw net fund outflows over every calendar year since 2007. This trend continued during the first quarter of 2016 with outflows from actively managed U.S. equity strategies totaling $44.7 billion and flows of passively managed strategies gaining $27.1 billion.

Investors often view U.S. equities as an efficient asset class for which the case for passive management is the most compelling. Based on fund managers’ stated prospectus benchmarks, only 21% of large-cap U.S. equity funds who benchmark against the Russell 1000 index outperformed their index over a trailing 10-year period. Within small-cap where informational inefficiencies are greater, 52% of funds who benchmark against the Russell 2000 index outperformed their index over a trailing 10-year period. Given that the majority of actively managed funds often underperform their stated benchmarks and charge higher fees in the process, it should come as no surprise that investors are gravitating toward passively managed funds. While active managers who can generate excess returns over time are certainly desirable, identifying those consistent generators of alpha can be quite challenging, especially for efficient markets like U.S. large-cap equities.