November 9, 2020 – Last month, I questioned whether the “dominance of large cap growth stocks is coming to an end.”
U.S. large cap growth stocks have powered their composite indices higher year-to-date, despite broad based economic weakness due to the lingering pandemic.
The investor appeal of the dominant growth stocks is largely powered by the level and direction of interest rates. With seemingly lower and lower interest rates, investors have been commensurately lowering their discount rates used in the computation of equity valuations. Lower discount rates used by investors have caused cash flows further into the future to become more valuable in discounted cash flow models, powering both the valuations and prices of large cap growth stocks.
The yield on the U.S. 10-year Treasury note bottomed at approximately 50 basis points in the fall. While it is foolish to attempt to call the bottom of the 40-year trend of declining interest rates, the reversal of this trend and a recent uptick in interest rates should be disconcerting to both growth stock speculators and stock market investors alike. If 10-year yields continue to rise, much of the wind behind the sails of U.S. large cap growth stocks’ expanding valuations could subside, pressuring the popular stock market indices such as the S&P 500 and the Nasdaq Composite, which have outperformed global peers meaningfully for over a decade.
In October, yields on the 10-year increased from 0.68% to 0.88%. Rising interest rates, combined with consternation regarding the U.S. presidential election, caused risk assets to sell off. While the premier stock market indices such as the S&P 500 and S&P / TSX 60 should form the core of investor portfolios, it is worthwhile considering what a diversified portfolio looks like in an era of rising interest rates and declining leadership of U.S. large cap growth stocks.
Accelerate manages five alternative ETFs and model portfolios, each with a specific mandate:
- Accelerate Absolute Return Hedge Fund (TSX: HDGE): Long-short equity
- Accelerate Arbitrage Fund (TSX: ARB): Event-driven
- Accelerate Enhanced Canadian Benchmark Alternative Fund (TSX: ATSX): Alpha + beta
- Accelerate Private Equity Alpha Fund (TSX: ALFA): Private equity replication
- Accelerate OneChoice Alternative Portfolio: Diversified alternative portfolio solution
As shown in the AlphaRank Factor Performance for October, risk premia including value, quality and operating momentum, provided positive returns on a market neutral basis while price momentum and trend generated negative returns throughout the month.
The Accelerate AlphaRank SPAC Index, encompassing all outstanding U.S. SPACs, declined -3.0% in October. ARB currently has approximately 70% of its portfolio dedicated to SPAC arbitrage. The ARB strategy was able to mitigate most of the weakness in the SPAC market by allocating to pre-deal SPACs that trade at or below NAV, in addition to merger arbitrage. Given these risk mitigation measures, ARB was able to limit its decline to approximately 1/3 of the SPAC Index’s loss for the month (the Fund’s first slight down month since launch).
A substantial uptick in new SPAC issuance has weighed on the market. However, this market weakness has led to three benefits for SPAC arbitrageurs: Increased liquidity, broader opportunity set and higher arbitrage yields. These three factors paint to an environment of higher expected returns on a go-forward basis.
ATSX provides investors with S&P / TSX 60 Index exposure combined with downside protection from a long-short equity overlay.
While the “buffer” provided by the overlay is meant to mitigate downside risk, it doesn’t perform every month. ATSX lagged the TSX 60 in October due to a negative contribution from the overlay portfolio. Nonetheless, given the overlay buffer reduced the Fund’s drawdown compared to the benchmark earlier in the year, ATSX remains ahead of the index by 7.5% year-to-date.
It is no secret that the “private equity factor”, defined as a leveraged small cap value strategy, has had a challenging few years. ALFA, which provides systematic exposure to the private equity factor driving leveraged buyout returns, has struggled.
Unfortunately for ALFA, given that it provides synthetic exposure to private equity through liquid public securities, it gets marked-to-market on a daily basis. This mark-to-market dynamic makes it look comparatively worse than traditional private equity in a bear market, given that traditional private equity gets to mark-to-model, delaying any portfolio losses and artificially smoothing returns to make the drawdowns of this high-risk strategy appear more palatable.
The notion that U.S. large cap growth stocks, whose valuation differential compared to value stocks reached an extreme level exceeding that of the tech bubble, have peaked provides believers in private equity with faith in its merits. Private equity is a long-term strategy that serves a purpose in diversified portfolios, despite its poor recent performance.
OneChoice offers investors a diversified sleeve of alternative investment strategies with the ease of just one choice. OneChoice is a portfolio solution that provides investors with exposure to a myriad of alternative investment strategies from six alternative asset classes. The goal of OneChoice is to provide an alternative return stream to augment the performance of traditional portfolios.
OneChoice played its role in October, generating positive returns while the traditional asset classes of stocks and bonds declined. The top performing asset class within the OneChoice portfolio was Bitcoin, with a gain of 30.6%, while real estate lagged with a decline of -5.0%. The other alternative strategies’ performance ranged from a gain of 0.1% to a drop of -3.7%.
Have questions about Accelerate’s investment strategies? Book a call with me.
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.