Commentaries

April 2019 - Disconnected from the fundamentals? - Systematic Fund Manager's Comments

30 April 2019

Emmanuel Hauptmann

 Key points

  1. How far market complacency can go?
  2. Large inefficiencies for fundamentally-driven managers
  3. Long/Short funds activity increased the dislocation already in place
  4. RAM Long/Short European Equities: strong positive asymmetry ahead of us

1. How far market complacency can go?

The wave of optimism in global risk assets, due in part to central banks’ action and hence market participants betting on a revival of economic growth, has created significant dislocation in equity markets. Considering the extent of the rally, it’s worth asking “has the market become too complacent?”, and more importantly, “are these inefficiencies built up over past quarters here to stay?”. We can answer part of these questions by analyzing the equity market’s behavior within a historical context, and most importantly by applying a fundamental lens to this analysis.

Macroeconomic fundamentals are not forthcoming! Comparing the Eurozone Citi Economic Surprise Index to the Stoxx 600 Index, we can reasonably assert that the disconnection between the two remains significant.

Eurozone Citi Economic Surprise Index vs Stoxx 600 (3M % change)

Eurozone Citi Economic Surprise Index vs Stoxx 600 (3M % change)

Source: Bloomberg, RAM Active Investments, as of 30.04.2019

One of the strongest risk assets rallies in such a short period of time

All risk assets are now comfortably sitting in positive territory YTD. This rally has been one of the fastest and strongest since 2009, with most equity indices having recouped their Q4 2019 losses. High yield credit has displayed very strong performance due to improving financing conditions for companies across the globe, but with no clear signs of a strong rebound in economic growth.

Performance by asset class

Performance by asset class

Source: Bloomberg, RAM Active Investments, as of 30.04.2019

Our models tend to source most of their short opportunities from highly leveraged companies, with deteriorating cash balance and a negative momentum evident from various angles. What’s striking is that fundamentals of these companies did not materially improve over past months! The complacency in the market underlining the large disconnect between asset prices and companies’ financial health oddly takes us back to the beginning of 2000; and many of you know what happened here.

Passive investment flows continue to support the market

In equities, flows into passive investment vehicles were one of the main drivers of returns. Net flows into equity ETF’s (both DM & EM) have exceeded USD 60 billion[1] since the beginning of the year. These vehicles are significantly tilted towards large/mega caps and growth names, which are highly dependent on foreign revenues, displaying concentrated sector and country bets. This has resulted in significant inefficiencies in certain segments of the market which have been overlooked. They are now offering significant opportunities for fundamental managers like us.  

2. Inefficiencies in equity markets are significant now

The sentiment and flow driven environment left a part of the market fully behind. As systematic managers, we believe the absence of human intervention is of outmost importance, especially during these times, in order to fully capitalize on a normalization of the abnormalities in the equity market. We don’t have a crystal ball in predicting the exact timing of this process, but we are convinced that given the extreme situation reached, it will occur sooner rather than later. 

We provide below one observation which is at extreme levels from a historical perspective and our strategies would fully benefit from a reversion of these excesses.

Value underperformance versus Growth is more than visible

Value names have been ignored by the market for several years now. To illustrate the severity of this move, we’ve charted the 10-year annualized return difference between Value and Growth stocks globally. By digging down into Growth names, we notice that growth projections for some companies have reached unrealistic levels, disconnected from both company’s historical growth trajectory and global macro indicators. If we consider a DCF model and apply a tweak to the discount rate, it appears that for a number of Growth companies, it could have devastating effects on their stock price.

MSCI World Value Index vs MSCI World Growth Index 10-Year CAGR

MSCI World Value Index vs MSCI World Growth Index 10-Year CAGR

Source: Bloomberg, RAM Active Investments, 30.04.2019

Strong divergence between long and short book fundamentals

The below table highlights the divergence between the long and short book fundamentals of our RAM Long/Short European Equities Strategy. What’s striking is the difference in both book’s metrics has reached extreme levels, unseen since we began managing this strategy. Historically, the strong positive returns of our strategies have followed this type of market configuration and we believe this time it’s not dissimilar.

RAM Long/Short European Equities: fundamentals of long & short book

RAM Long/Short European Equities: fundamentals of long & short book

Source: RAM Active Investments, as of 30.04.2019

3. Fund flows exacerbated the already large inefficiencies

Equity market neutral funds have experienced a challenging period. In general, the confidence expressed in the YTD market action has remained limited and some outflows have pushed these funds to cut both long and short positions, which tend to have similar fundamental biases. Again, these circumstances are not new to us as it tends to happen during regime change phases, with subsequent quarters turning out to be highly favorable for our strategies.  

European Long/Short funds do not display full confidence in the rally

In Europe, average gross & net leverage for Long/Short funds have been significantly reduced during Q4 2018. This “deleveraging process” negatively impacted our performance during that period. Subsequently, in Q1 2019, the gross exposure has returned strongly, namely due to high net exposure funds, but average net exposure has stayed at low levels, translating into increased long/short opportunities for the investment funds community, but not necessarily full confidence on the extent of the rally.  

Average gross & net leverage of European Long/Short funds

Average gross & net leverage of European Long/Short funds

Source: Morgan Stanley, as of 26.04.2019

Outflows in Equity Long/Short funds penalized our books

Equity long/short funds globally were subject to outflows YTD. When we dig into these negative figures, we see that some equity market neutral funds have been suffering large redemptions. For instance, a market neutral vehicle, run with 300% leverage, would need to liquidate four times the amount of redemptions, exacerbating the trend in place with shorts being bought back and longs cut.

Assuming these asset managers have similar biases to us (e.g. long quality & high CF generative companies and short highly levered & negative earnings trend names), this has amplified the large dislocation already present in the market. Our strategies have always been a strong net beneficiary after such periods.

Net flows by month in Alternative Equity Market Neutral funds

Net flows by month in Alternative Equity Market Neutral funds

Source: Morningstar - Alternative Equity Market Neutral Category, as of 29.03.2019

4. Positive asymmetry for our strategies 

Resilient in times of stress

On top of the large inefficiencies created by recent market activity which our Strategy can be expected to capitalize on, the Strategy would preserve/grow capital in most of the realized historical stress periods.

A true portfolio diversifier

RAM Long/Short European Equities provides low to negative correlation to traditional asset classes, proving to be a real portfolio diversifier over the long-term. Additionally, over time the linear relationship of the Fund to various indices is highly dynamic (when seen through 12-month rolling correlation angle). 

RAM Long/Short European Equities vs Indices - correlation of monthly returns (04.2009 – 04.2019)

RAM Long/Short European Equities vs Indices - correlation of monthly returns (04.2009 – 04.2019)

Source: Bloomberg, RAM Active Investments, as of 30.04.2019

Conclusion

The dislocation created by current market complacency is typical to regime changes in financial markets. Several metrics are pointing to a reversal of the situation and most importantly to the fact that the focus on fundamentals should happen soon. Our strategies have been net beneficiaries during the normalization phase following these periods. We are strongly convinced that the return to the mid- to long-term performance pattern is in sight considering the extreme market conditions prevailing at the moment. 

RAM Long/Short European Equities – monthly track record (gross of management and performance fees, 04.2009 – 04.2019)

RAM Long/Short European Equities – monthly track record (gross of management and performance fees, 04.2009 – 04.2019)

Source: RAM Active Investments, based on monthly data, as of 30.04.2019

Note: RAM Long/Short European Equities Strategy shows performance gross of fee of the RAM L/S European Equities Fund and of the RAM Absolute Return Fund prior to December 2011.  The RAM Absolute Return Fund followed the same exact investment strategy within a Cayman vehicle before it was converted to a UCITS. Past performance is not a guide to future performance.

[1] Source : Bloomberg, as of 30.04.2019

 

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