May 11, 2021 – Aside from numerous peculiar and obvious asset bubbles, rationality and sensibility have seemingly returned to the market, at least on a relative basis.
Indicative of this rationality returning is reflected in the underperformance of glamour and hyper-growth story stocks and the outperformance of intelligent investing based on factors such as value, quality and momentum. Research shows that historically, glamour stocks have underperformed the broad index. In contrast, investing based on factors such as value, quality and momentum (also known as alternative risk premia) has led to significant outperformance.
However, the relationship between the outperformance of factor investing and the expected underperformance of glamour stocks flipped over the past decade, reaching its most extreme level of disparity in 2020. Over this period, growth investing outperformed so dramatically that it left market participants questioning why they would pay attention to value or quality metrics anymore, assuming that this old style of investing based on fundamentals had become obsolete.
One year after the pandemic market plunge of March 2020, an important market shift is occurring. Alternative risk premia, led by value (which has woefully underperformed over the past decade), have gone back to their outperforming ways. As value stocks continue to rally, they turn into momentum stocks, leading to the “sweet spot” for systematic investors. This value-momentum convergence is known as the holy grail of quantitative investing, given its ability to supercharge returns.
Glamour stocks have taken it on the chin year-to-date, suffering double-digit declines, a complete reversal of last year’s and last decade’s relative outperformance. At some point, a stock will be viewed as the present value of its future cash flows and cannot remain exceptionally overvalued forever. The major catalyst in driving this revaluation of glamour stocks is the steady rise in interest rates, making the hyper-growth stories less appealing to investors, reducing their valuations. We expect the revaluation of yesteryear’s favourite growth stocks to turn into a multi-year period of underperformance, as relative valuations of growth stocks revert to the mean from their widest levels on record.
This expected secular decline in the valuations of growth stocks, combined with the slow recovery in the sentiment of value stocks, could lead to an environment akin to 2000 to 2003. During this 3-year period, the S&P 500 suffered a gruelling, multi-year bear market as the high-flying technology issues from the tech bubble came crashing down to earth.
Meanwhile, undervalued securities of high-quality issuers, which the market had ignored for years, experienced a complete 180-degree turn in sentiment and experienced double-digit returns during this period of broad-market weakness. Further buoying this dynamic was that as value stocks consistently went up, they became momentum stocks.
Hedge funds correctly positioned for this environment, being long undervalued, high-quality securities and short low-quality, overvalued story stocks, generated significant outperformance. In fact, the average hedge fund was beneficially positioned over this time period, leading to the “golden age of hedge funds”, as the asset class enjoyed one of its greatest ever periods of outperformance.
The current market set-up seems eerily similar to late 2000 / early 2001, when growth stocks were crashing and undervalued equities were rallying. Time will only tell if we are at the onset of another golden age. Nonetheless, investors should consider correctly positioning for this scenario.
Accelerate manages four 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
Speaking of investing “sweet spots”, arbitrage investors currently have an opportunity set positioned for low-risk and high returns.
One dynamic in the arbitrage market that caused us tremendous consternation occurred in January and February. For the first time, not a single SPAC in the market was trading at a discount to NAV. This situation was highly problematic for two reasons. First, it made capital deployment extremely challenging (who wants to invest at negative returns?). Second, it presented significant downside potential if the SPAC market were to revert to NAV.
Also, at this time, the merger market was moribund. Not a lot justified significant capital deployment to merger arbitrage at that time.
Three months have passed and the arbitrage market could not be more different. Now approximately 80% of SPACs are trading at a discount to their net asset values, leading to what we refer to as an “arbitrageur’s paradise.” If we examine the difference between the market capitalizations of the more than 400 discounted SPACs and their underlying net asset values (of which investors can receive upon redemption or liquidation), we find there is approximately $1.4 billion of virtually-free money available for investors. They just need to pick it up.
In addition, the activity in M&A is picking up steam. We are witnessing an increasing number of bidding wars in key merger situations break out, leading to above average returns for arbitrageurs.
The Accelerate Arbitrage Fund (TSX: ARB) is positioned to capitalize on both of these market dynamics, including discounted SPACs and attractive merger arbitrage opportunities with bidding war potential.
HDGE jumped 5.4% this month as the average long rose 5.2% while the average short rose just 0.1%.
Nearly every factor generated alpha in April. On a long-short market-neutral basis, value was up 4.4%, followed by quality’s 4.0% rise, price momentum’s 2.4% gain and the 2.0% uptick for operating momentum. The only losing factor last month was trend, which fell -0.9%.
Notably, the market is now discerning between valuations, with undervalued securities outperforming markedly. The long-short value factor generated alpha not just from the long side, which gained 3.7%, but also the short side, which fell -0.7%. Given the extreme valuation divergence between low valuation and high valuation equities recently reached, we think this relative value relationship will take years to mean-revert.
ONEC eked out a 0.1% gain in April. In contrast to February and March performance, bitcoin fell while the remaining asset classes rallied.
Long-short equity led the positive performance, up 5.4% for the month. Gold rallied 4.5%, real estate ticked up 4.2%, buffered index gained 3.6% and the infrastructure allocation rose 3.1% in April. Arbitrage, leveraged loans and mortgages gained less than 2.0%.
Bitcoin dropped -4.8%, and when combined with weakness in USD, offset the majority of ONEC’s other asset class price performance for the month.
ATSX’s long-short overlay portfolio added 1.4% of outperformance on top of the benchmark in April.
This outperformance was driven by the alpha generated by the following factors which may up ATSX’s long-short overlay: Price momentum gained 5.1%, value rose 4.7%, operating momentum increased 4.2% and quality generated 3.8% of alpha. Trend was the only declining factor, with the long-short trend basket declining -2.7% on the month.
For the four factors that generated alpha last month, each of the factor long portfolios outperformed the index while each of the factor short portfolios underperformed the index. This is the goal of multi-factor long-short investing. When combined with index exposure, as ATSX has, it provides a value-added return stream for investors.
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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.