Hedge Fund Returns

Thanks to eVestment, a snapshot of hedge fund returns through February.

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Momentum Revisited

As we discussed last week, momentum is among the prominent anomalies in stock markets. A momentum strategy that buys winner stocks with higher recent returns and/or shorts loser stocks with lower recent returns generates positive average profits in the short run. However, there remains questions about its validity and persistence over time and across different market states.

We approached it on our own way. We devised nine different portfolios with a combination of backward looking relative returns and the size of holdings. We looked at stocks trading on the NYSE and NASDAQ of over $1 billion in market capitalization and stocks above $5 per share. As discussed in Friday’s post, momentum strength is relative to that of the index. As such, we sorted those stocks by those with the gross excess returns compared to the S&P 500 Index. Our portfolios held the stocks with the greatest excess return. The Bloodhound dataset is a 28-year point-in-time database that is free of survivorship bias. It includes companies that traded “x” many years ago, but no longer trade today. The pricing calculations are computed daily, and thus do not have the distorting effects that many point-in-time databases have of only calculating changes and rebalances weekly or monthly.

If our ranking methodology has value, one should see improving returns as the portfolio’s concentration of holdings increases. A combination of ranks 1-10 should (in theory) outperform a portfolio of 100 equally weighted ranks if the ranking methodology has some legitimacy. The fact that our portfolios show such qualities indicates that the momentum concept appears to hold water.

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Regardless of the momentun period surveyed, in each case, the 25-stock holdings outperforms the 50-stock holdings which, in turn, outperforms the 100-stock holdings. Also, as you would expect, correlation with both the S&P and the Russell 2000 increases as the porfolio becomes more diverse.

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As one might expect, the Betas of the portfolios are quite high, ranging from 1.2 to 1.42x. The portfolios outperform the S&P 500 on a annual basis between two-thirds and 70% of the time. And the swings are big.

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It works well, expect when it doesn’t. When the stratgies outperform the S&P, they do so significantly. However, when they underform, they do it in spades as well. Notably, the startegies were down around 60% in 2008, and to a lessor extent in 2000 and 2002. Although 20-year cumulative returns beat the S&P 500 and the Russell 2000, the volatility associated with those returns come with a higher risk. Each portfolio’s Sharpe Ratio over that same period in considerably lower than that of the index.

Note that when we shorted the evaluation time horizon from 20-years to just five, the returns lag the indicies AND the volatility remains higher. Additionally, the ranking methodology appears to be more haphazzard. Note also that standard 5-year return figures in finance no longer include 2008 in the mix.

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Over a long period it appears that momentum has validity, although, like in life, the timing is considerably important. Some have taken to qualify the timing aspect. In 2004, Cooper, Gutierrez, and Hameed documented that momentum profits are higher following positive market returns than following down markets. More recently, Daniel and Moskowitz (2013) show that negative momentum profits often occur in markets where a down market is followed by an rising market. For more information, and testing of those theories, review the associated student academic paper from at the Wisconsin School of Business, University of Wisconsin-Madison which won the award for Best Doctoral Student Paper Award at the Academy of Behavioral Finance & Economics (ABFE) Meeting in 2012.

We will look at our own adjustments to the strategy later this week, as the momentum continues…

Mo

Momentum is the tendency of investments to exhibit persistence in their relative performance. It’s a derivative of Newton’s first law of motion: an object at rest will remain at rest, an object in motion continues in motion. A stock on its way up tends to continue going up, and a stock on its way down tend to continue to go down. Inertia, or persistence.

Momentum is about much more than buying a handful of hot stocks. It is a disciplined, systematic investing style based on investor behavior – an asymmetric response to winning and losing investments. As detailed by Adam Berger and Israel Ronen of AQR and Professor Tobias J. Moskowitz of the University of Chicago – momentum can be a complement to both a growth and a value strategy. In their Case for Momentum Investing, they note the data suggests that the stocks with the best momentum outperform the ones with the worst momentum, both in absolute terms and relative to the equity market as a whole.

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If true, the existence of momentum would challenge the efficient market hypothesis (EMH) that past price behavior provides no information about future behavior. However, evidence already suggest that the EMH is not exactly as efficient as it claims. In asset pricing and portfolio management, the Fama-French three-factor model (among other studies they did) conclude that anomolies are present in the market that traditional EMH studies would suggest cannot exist. Particularly, small companies and value companies had persistently higher returns than the Capital Asset Pricing Model (CAPM) could explain. They showed that there are risks (market, size and value) with systematic prices attached to them and in combination explain performance. These risks are called priced risk because we can identify additional return for accepting them. Berger, Ronen and Moskowitz believe momentum is one of them.

Some of the explainations for the basis of momentum include the fact that investors may be slow to react to new information, and they update their views only partially when faced with such information, slowly accepting its full impact or potentially over-reacting to the newest news. Under-reaction and over-reaction may reinforce one another since they typically operate over different time horizons. Other factors include the disposition effect – Investors tend to sell winning investments prematurely to lock in gains, and hold on to losing investments too long in the hope of breaking even, creating an artificial headwind. The authors conclude that the net result is that momentum will persist for a period of time (6-12 months) before ultimately leading to reversals as too many investors pile on and prices become detached from fundamentals. Their evidence shows that assets that have performed well over the last 12 months tend to do better over the next 3-12 months than assets that have performed poorly over that same period.

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In particular, the authors note that Momentum offers better returns than growth and is a better complement to value. Their calculation of large and mid-cap momentum earned an average of 300bps premium of annual return over the Russell 1000 Growth Index for roughly the equivalent annual volatility. Compared to the Russell 1000 Value Index, it offered a higher return in exchange for higher volatility. Although Momentum slightly edges Value, the two strategies are roughly equivalent in Sharpe Ratios. However, Value’s correlation to Momentum is a significant -0.5, providing interesting diversification benefits.

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We have looked at the topic of momentum a few times, both on a short-term and longer-term basis. Particularly, our studies on “Falling Knives“, evaluated a possible mean-reverting strategy of investing in stocks that had major downward movements. Let’s just say, it wasn’t good. The long-term average annual return depending upon the holding period was around -3%.

Short term reversal strategies fared even worse. We looked at stocks that had 20% negative movement over a 20 day period. The results were worse.

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Although it performed well in periods where you might expect, it significantly trailed the S&P 500 pretty regularly. As such, following the momentum in both this case and that of Falling Knives would have served us well.

Next week, we will take the reverse (no pun intended) and use our system to evaluate strategies that follow upward momentum…

Are the Rich Getting Richer?

Forget about the 1%’ers, look at the 10%’ers, says AllianceBernstein. They wrote an interesting blog post a week or so ago about the widening gap between in the rich stocks and the value stocks.

In the aftermath of last year’s market party, the most expensive quintile of global stocks now trades at 8.1 times book value, or almost four times higher than the global stock market as a whole—the second-highest premium since 1971 (Display 1). Earnings multiples are similarly hefty. Meanwhile, the cheapest quintile sells at 0.9 times book value, a 57% discount to the market and around its historical average in both absolute and relative terms. In the past, differences of this magnitude between the valuations of cheap and expensive stocks have heralded outsized value outperformance. Eventually, either the controversies that caused the disparity resolved themselves or cheap stocks simply became too enticing to resist.

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Author Chris Marx notes that Consumer Cyclicals & Staples, Medical and Technology sectors are among the highest P/BV valuations and Financials, Housing and Utilities are among the lowest. Neither of those two facts should be all that surprising as those sectors typically exhibit such a split due to accounting treatment of assets and intangibles as well as valuation preferences regarding growth. However, I think his point is the magnitude of the gap.

Using Bloodhound’s AlphaFactor tool, we are able to quickly analyze factors contributing to performance. Bloodhound’s simulation engine queries our proprietary database of U.S. and Canadian stocks (and U.S.-listed ADRs) back to 1987. The “as-reported” and unadjusted dataset enables the recreation of real-world peformance free of survivorship bias and look-ahead bais. As such, we chose to look at the return profile of holding the richest and cheapest stocks. Rather than focus on book value which can be skewed by accounting treatment of tangible and intangible assets, we looked at forward P/E valuations. We compared portfolios of the highest forward P/Es against a portfolio of the lowest forward P/Es, each qualified by being listed on the NYSE or NASDAQ and greater than $1bn in market cap. We set up rules to buy the 100 highest (lowest) stocks, and held them for at least 30 days, and rebalanced the value amongst the portfolio once a month.

Due to the assymetric returns of the equity market, both strategies have positive geometric returns; however, the low P/E strategy has substantially outperformed the high P/E strategy over the the last 28 years. In the last eleven years, the S&P 500 has finished in the black in all but one (2008), and the high P/E strategy underperformed in 50% of them, while the low P/E startegy only underperformed in one. Neither strategy did particularly well during the high correlation period of 2008. Both strategies massively underformed the S&P 500.

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The correlation between the two strategies are stong (87% on a yearly basis, and 89% on a monthly basis), their return profiles are widely different. While high P/E is outperforming so far this year, low P/E outperformed for the 16 straight months ended December 2013.

As Bernstein points out, the widening gap in valuation may be tilting the field in favor of value stocks, but the field was already tilted.

February Rebound

January was a dificult month for sure. No effect, that is. February was a little different story. Equities recovered from January’s losses in fine style. The Nasdaq lead the pack among the major indicies, but by the end of the month the S&P 500 had set an all-time closing high. The small caps of the Russell 2000 also had a strong month, leaving the Dow industrials the only one of these four domestic indices down for the year despite its February gains.

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The second month of cuts in the Fed’s bond purchases seemed to have little impact on the benchmark 10-year Treasury yield. Meanwhile, gold saw a rebound from its recent losses, gaining almost $100 an ounce and hitting its highest level so far this year before settling back a bit to end at roughly $1,320. The U.S. economy grew a bit more slowly in Q4 2013 than previously thought (2.4%). According to the Bureau of Economic Analysis, that put growth for all of 2013 at 1.9%. Congress agreed to avoid renewed conflict over an increase in the debt ceiling by passing legislation that resolves the issue until March 2015 – and President Walker and Vice President Underwood relaunched their efforts to speak to the American people February 14th.

As defined by Barron’s, “junk bonds continue to defy gravity and mathematics, soaring through the first two months of 2014 with a 2.76% return, even though the market entered the year yielding just 5.6%. That average yield is down to 5.2% now, and the average junk-bond price is up to 104.9 cents on the dollar, with an average spread over Treasuries of 3.81 percentage points, a fresh post-crisis low.”

Manufacturing showed signs of slowing in the United States, where durable goods orders were down for the third of the last four months thanks to a decline in transportation-related orders and the Institute for Supply Management’s gauge fell more than 5%. Meanwhile, Markit/HSBC’s survey of Chinese purchasing managers showed contraction there, though seasonal distortion may have played a role. Housing suffered from frigid weather throughout much of the country. Housing starts, building permits, and sales of existing homes all saw declines, though new-home sales were up slightly for the month and construction spending also rose. Inflation remained well within the Fed’s comfort level. The biggest monthly increase in the cost of electricity since March 2010 pushed up consumer prices by 0.1% for the month, putting the annual rate for the last 12 months at 1.6%. Meanwhile, the Bureau of Labor Statistics said the wholesale inflation rate was up 0.2% in January, but the annual rate was only 1.2% over the last year.

Among industries, we track six of the major categories through the largest 10-, 20- and 50-capitalized stocks. Even though each sector performed well, Healthcare continues to lead the pack. Depending upon the size of the portfolio, the Healthcare sector is up between 7-8% year-to-date.

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Only five of the 50 largest capitalized healthcare stocks generated a negative return for February, and two of those would have rounded to flat. Cigna (CI) was the only real negative drain down 8.9%. Conversely, 40th ranked Forest Labs (FRX) and 41st Mylan Labs (MYL) ripped up 45% and 22% respectively. Actavis (ACT) agreed to acquire Forest in a cash-and-stock deal valued at $25 billion. Upon the heels of that merger, investors sought what generic drug maker might be next – and their answer was Mylan.

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But as we noted above, the two generics were hardly alone in their February rally. Take Merck (MRK) which has been on the move since November, and really an upward trajectory since Summer 2011.

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Among Financials, only Bank of America (BAC) lost ground among the top names, and has been trending that way all year.

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Despite strength as a group, only Consumer Cyclicals showed some variability among the largest names. Wal-Mart (WMT; -0.7%), Toyota Motor (TM, -1.0%); Comcast Corp (CMCSA, -6.3%); Honda Motor (HMC, -3.0%); and Starbucks (SBUX, -0.9%) lost value in February.