Capital market themes in 2016 – A buyside perspective
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Capital market themes in 2016 – A buyside perspective

A buyside review of 2016
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The beginning of a new year is always a good time to look back at the bygone year, to reflect on key trends, note key learning, and plan ahead for the new year. When I reviewed capital market events in 2016 from a buyside (asset management) perspective, among other trends, two key trends caught my attention – a) changed behavior of equities, and b) strong emergence of Quant funds. The global asset management industry is treading a stressful path with too much of systematic and unsystematic risks acting against it. In addition, the well-informed investors are not only questioning the relatively higher management fees, but also the fund managers’ existence in this competitive world.

Let’s take a quick look at some of the key trends of the buyside industry in 2016. Am sure there are many more trends, however I have highlighted only those which I could validate through our study or/and from the authentic industry sources.

 

Equity has behaved more like ‘fixed income’ instrument! And, increased dividend payouts with increased debt capitalization is concerning

One of the key themes of 2016 was the change in the core characteristics of the asset classes particularly – equity and fixed income. Traditionally, equity has been a preferred asset class for achieving capital appreciation, and fixed income is known as a regular income avenue. However, over last 12 months, these asset classes have kind of swapped their original characteristics as far as the US is concerned. The US companies have increased dividends payouts to the shareholders over last year, thus positioning it as an income generating security. Not sure if this is driven by management’s KPIs to maintain the shareholders’ value. However, the most striking concern is that majority of these companies (with increased Dividend per Share or DPS) also have shown increased debt borrowings in their capital structure. As a fixed income investor, it’s a credit-negative when a company increases its borrowings on one hand and also increases its dividend payments to equity holders on the other.

The following are the findings from our study of the US & European equity and fixed income markets which highlight trend in dividend distribution along with rise in debt capitalization:

  • Of 65 companies in Dow Jones, 47 companies (72%) reported y/y increase in their DPS; with an average increase to 19.5%
    • Of these 47, 32 companies (68%) reported y/y increase in debt capitalization ratio (debt/total capital); with an average increase of 19.1%
  • Of the FTSE 100, only 3% of companies reported y/y increase in DPS; with an average increase of 26.7%
    • And of these 3 companies, 2 companies reported y/y increase in debt capitalization ratio; with an average increase of 23.1%
  • The fixed income markets outperformed the equity markets by a decent margin, proving that it is better positioned as a capital appreciation investment vehicle. The fixed income indices (Barclay’s and BoFA US HY indices) have outperformed both, S&P 500 and Dow Jones in CY2016 (see table below). However, had severely underperformed in CY2015 (Barclay’s US HY Index: -4.51% and Dow Jones: 1.24%)

 

Buyside faced increased pressure on returns and fees, amidst turbulent/volatile markets

The managers had a tough 2016, in terms of creating alpha, managing redemptions, high market volatility, managing various risks (including interest, macro, geo-political, and market risk) and increasing competition. They experienced downward pressure on fees, in case of relative underperformance. When I spoke with a couple of my clients & managers in one of the hedge fund conferences, the consensus was that the pressure on fees will continue; and the concept of 2/20 will slowly be out of flavor due to following factors:

  1. Low alpha generation due to unfavorable or volatile market conditions
  2. Investors are extremely return-cautious and cost-sensitive in these uncertain times
  3. Index is not a benchmark to beat anymore; it’s the competition which always outperforms the indices!
  4. Increasing competition from new traditional funds, ETFs, and Quant funds in the market

I think a relatively underperforming fund manager undoubtedly will have to justify its management fees. All these above factors may prevail in 2017 too, and may push the fees further down. However, the best fund managers will deliver superior returns and will also command commensurate fees – there are no free lunches!

 

Emergence of Quant Funds – a boon or curse to the fund industry & the investors?

As per the Institutional Investor’s annual list of top earning hedge fund managers (May 2016), six of the top eight are quant funds, or managers who rely on computer programs to guide their investing. The list includes Ken Griffin of Citadel, Jim Simons of Renaissance Technology, and John Overdeck and David Siegel of Two Sigma. The Quant funds compete with traditional hedge funds on unmatched features (read competitive advantages) including scientific data-driven investment decision-making, technological architecture & sophistication, speed of execution, and low cost of fund management. Considering the pace at which the popularity of the quant funds has grown and is growing, the traditional asset managers will have hard time winning against these asset management robots. And, even these quant funds will compete with each other to differentiate among its peers. An investor would choose a ‘right’ manager after scrutinizing the following parameters (read as differentiators):

  1. Fund’s investment management expertise
  2. Size of assets under management
  3. robustness of the algorithm of the investment platform,
  4. technology infrastructure
  5. the quality of underlying data, and last but not the least,
  6. consistency of performance in different market situations (bulls/bears/crisis)

 

International hedge funds shied away from the emerging markets (EM) in 2016, and the trend is likely to continue in 2017

The emerging markets (including UAE, KSA, Oman, Russia, Malaysia, and India) offer some good investment opportunities. However, when it comes to EM exposures in portfolios of global hedge funds, it is often small and is limited for hedging or diversifying the portfolio risk. And, some of the fund-of-funds even invest through global mutual funds that operate locally, to avoid direct exposures.

The performance of key indices speaks for the low exposures to EM asset class. In last 12 months, the developed markets have outperformed the emerging markets, with an exception of MSCI World Index. The 12-month returns for Dow Jones, FTSE 100, and MSCI World Index are 16.50%, 19.15%, and 8.18%, respectively; against 11.27% for MSCI Emerging Market Index. The unfavorable risk-return profile of EM makes it relatively unattractive and restrictive when it comes to fund exposures. In addition, the US Fed rates are expected to further increase in 2017, which is expected to benefit the US GDP growth and the US dollar. However, it’s not so good news for the EMs, and it’s highly unlikely that any additional money will flow into EM soon.

12-month daily total returns as on December 30, 2016
Indices Total Returns
MSCI Emerging Market Index 11.27%
MSCI World Index 8.18%
Dow Jones Industrial Average 16.50%
FTSE 100 Index 19.15%
S&P 500 Index 11.95%
Barclays US High Yield Index* 17.13%
BoFA ML US High Yield Index* 17.49%
Barclays Pan-European High Yield Index* 6.48%
Source: Bloomberg, ValueAdd Research

* Excludes and coupon or dividends

 

Source: Bloomberg, ValueAdd Research, Business Insider

 

Please feel free to share your thoughts or some trends that you have observed on info@valueadd-research.com. Thanks for your time.

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