January 11, 2022 – From 2000 to 2004, as the growth bubble popped and value stocks came roaring back, a “golden era” for long-short equity hedge funds occurred.
The tech bubble implosion in the early aughts bears remarkable semblance to the current market environment.
For example, the valuation spread between the Russell 1000 growth and value indexes surpassed its tech-bubble high, prior to the recent growth bubble stock rout.
In 2000, after the bubble popped, equities fell -50% over the following three years. That decade, US equities returned approximately 0%.
As the dot-com bubble popped, equities went into a tail-spin due to extreme valuations combined with a recession. During this period, long-short equity hedge funds could capitalize on the extreme dispersions in stock valuations, producing strong returns throughout the equity bear market. This “golden age” for long-short equity, in which long-short hedge funds were able to maintain positive returns and materially outperform the equity index throughout the 2000-2003 equity bear market, was lucrative for hedge fund investors.
Source: Beachhead Capital Management
I believe, starting in 2021, we kicked off a new multi-year run in which the growth bubble pops and value stocks come roaring back. This market dynamic may create another “golden era” for long-short equity, likely lasting several years.
Twelve years of the easiest monetary policy of all time, characterized by trillions of dollars of quantitative easing and interest rates that were held too low for too long, created the widest dispersion between growth stocks and value stocks. This record dispersion has led to perhaps the most fruitful environment for long-short equity hedge funds.
Relentless priming of the pump by central banks inflated many growth stocks to 10x their intrinsic value. Since peaking, some of these glamour stocks have fallen -50%. However, this still leaves them 5x overvalued, equating to a -80% additional downside. The key ingredients for the bull case for growth stocks, including QE, momentum, FOMO and sentiment, are long gone.
Meanwhile, sectors exhibiting value characteristics, such as energy, financials and industrials, were left for dead. “Old economy” stocks at single-digit price-to-earnings ratios had no place in the age of relentless QE. As a result, negative sentiment for quality and value stocks has turned, and generalists are buying these securities once again.
We believe the time to be long quality + value and short overvalued glamour + junk is upon us. It will take multiple years to correct the market excesses caused by central banks and rectify the record dispersion between value and growth.
Last year was great for long-short equity, but we believe the move just started and that investors can look forward to a continuation of this trend well into this decade.
Ben Graham once claimed, “in the short run, the market is a voting machine but in the long run, it is a weighing machine.” Value is expected to outperform growth, while quality is expected to outperform junk. Historical data indicates that this is how markets typically behave. Evidence-based investing does not work every year, although it is expected to be effective over the long run.
Low-quality, overvalued stocks outperformed for the past dozen years. High-quality undervalued stocks are finally outperforming over recent months, but it will take several years to reverse the past 12 years of market excesses. This trend has legs. Investors need to hop on and enjoy the ride.
Accelerate manages five alternative ETFs, each with a specific mandate:
- Accelerate Arbitrage Fund (TSX: ARB): SPAC and merger arbitrage
- Accelerate Absolute Return Hedge Fund (TSX: HDGE): Long-short equity
- Accelerate OneChoice Alternative Portfolio ETF (TSX; ONEC): Alternatives portfolio solution
- Accelerate Enhanced Canadian Benchmark Alternative Fund (TSX: ATSX): Buffered index
- Accelerate Carbon-Negative Bitcoin ETF (TSX: ABTC): Eco-friendly bitcoin
ARB declined -0.7% in December and gained 7.4% for the year.
ARB’s annual return for 2021 beat its benchmark, the S&P Merger Arbitrage Index Total Return, by 140 bps. Not only has ARB materially outperformed its benchmark since inception, however, has done so with near 0% correlation to the TSX 60 stock index (as you should know, arbitrage is a different asset class than equities). Low or negative correlation is the true indication of an alternative investment strategy and portfolio diversifier.
While lower than 2020’s abnormal 29.8% return (which is unlikely to be repeated), ARB’s 7.4% return in 2021 was right in line with our 7-8% annualized return target. The main goal of ARB is to produce consistent, low-volatility returns without suffering a down year while maintaining its low-risk rating. In addition, ARB has rewarded its investors with two years of back-to-back double-digit quarterly distribution increases.
We entered 2022 well positioned in ARB, with a gross long exposure of approximately 160% and a portfolio consisting of 80% SPAC arbitrage and 20% merger arbitrage. Given how high arbitrage yields are currently, we expect once again to be in a position to achieve the fund’s goals for investors in 2022.
After a tough two years for long-short equity, in which shorting low-quality junk stocks was a recipe for portfolio pain, long-short factors such as value and quality are once again generating alpha.
For example, as last month’s U.S. AlphaRank Factor Performance indicates, undervalued stocks gained 4.1% while overvalued equities lost -5.7% in December. Meanwhile, high-quality stocks gained 4.5%, while low-quality stocks lost -5.5%. Being long “good” while being short “crap” has been working well lately, and we see no reason why it would not continue.
It is important to note that HDGE’s returns since inception have been slightly negatively correlated to the TSX 60 index. A negative correlation indicates that it generally moves independently or slightly the opposite of the broad-based equity index, living up to its ticker symbol as a potentially appropriate portfolio hedge.
ONEC finished December up 0.5% and gained 12.6% since its January 27, 2021, inception. It generated this since-inception return with an equity beta of 0.45 and a correlation to the TSX 60 of just 35%.
Last month, positive contributors within the ONEC portfolio include alternative equity’s 7.3% surge and long-short equity’s 6.2% gain, with infrastructure and real estate contributing 6.0% and 5.0% returns, respectively.
The main detractor was bitcoin’s -21.9% loss for the month. Nonetheless, ONEC has continued to generate respectable positive returns even during a bitcoin bear market. The ONEC asset allocation framework was designed to hold a diversified portfolio of uncorrelated strategies. As such, it is expected that most will move independently of not only the broad-market indexes but also the other strategies within the portfolio.
ATSX jumped 7.3% in December, notching one of its best monthly returns on record. As shown in the recent AlphaRank Factor Performance, the long-short factors behind ATSX’s long-short buffer portfolio continue to generate alpha. For instance, Canadian stocks with top-ranking factor characteristics gained 6.6% last month while those with bottom-ranked factor characteristics dropped -5.2%.
The fund gained 27.9% for the year, in line with its benchmark. The notable characteristic of ATSX is that it has matched the benchmark’s performance while only exhibiting an 89.6% downside capture since inception. In addition, ATSX provides a 7% distribution yield for those investors seeking income.
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Disclaimer: This distribution does not constitute investment, legal or tax advice. Data provided in this distribution should not be viewed as a recommendation or solicitation of an offer to buy or sell any securities or investment strategies. The information in this distribution is based on current market conditions and may fluctuate and change in the future. No representation or warranty, expressed or implied, is made on behalf of Accelerate Financial Technologies Inc. (“Accelerate”) as to the accuracy or completeness of the information contained herein. Accelerate does not accept any liability for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on all or any part of this research and any liability is expressly disclaimed. Past performance is not indicative of future results. Visit www.AccelerateShares.com for more information.