Levered Beta Plays Are No More
(March 22, 2009)
Dear Subscribers and Readers,
The Capital Asset Pricing Model (CAPM) is an elegant model. Conceived in 1964 by Bill Sharpe, John Lintner, and John Mossin, it remains a centerpiece of modern financial economics and to this day, provides a good framework for understanding the relationship between the risk of an asset and its expected return. Within the investment world, the CAPM serves as a general “equilibrium framework” for understanding the sources of returns (e.g. alpha vs. beta) and the issues that arise from trying to generate alpha in every outstanding asset class.
As an undergraduate majoring in Mathematics and Economics at Rice University in the 1990s, it was obvious from the get-go that the assumptions underlying the CAPM were devoid of real-world characteristics. In a nutshell, the CAPM assumptions (seven in all) try to ensure that individuals are as alike as possible, with the investment environment devoid of real-world distortions such as taxes, transaction costs, and differences in borrowing rates. More importantly, the financial markets are assumed to be in equilibrium. While I have always done well in academics (I got an “A+” for that particular economics class), I also believed that the CAPM had no practical use outside of the classroom or on the CFA exams. This is particularly true for active managers whose main goal is to beat their benchmarks and prove that academia is wrong, especially when it comes to the theory of “efficient markets.”
Since the dawn of the modern university (or business school), practitioners have often derided scholars for making simplified assumptions or for having no experience in the “real world.” In many cases, this criticism is well taken. But this criticism also cuts both ways. For example, how many entrepreneurs, finding early success, have eventually run their businesses to the ground? What about the many successful CEOs who have struggled with acquisitions that was initially regarded as attractive? The greatest examples are those found in the financial industry over the last 18 months. Many practitioners (CEOs) who had built great long-term track records in the financial industry ran their companies into the ground during this period, including Lehman's Richard Fuld, Washington Mutual's Kerry Killinger, and Wachovia's Ken Thompson. What good is a practitioner if he doesn't study or understand the prospects of his own business or industry?
The truth is that the CAPM is more than a bunch of equations – and is in fact a very useful framework that allows both scholars and practitioners to think about the investment world on a very high level. In particular, we understand from the CAPM that at true equilibrium, there are only two possible sources of returns – that of the risk-free rate and the “beta” return (the return from exposure to the market). Just like a physics model that does not take into account wind resistance, this equilibrium state is not only unrealistic, but also uninteresting. Only when this model is constantly in disequilibrium (similar to what occurs in the real world) does it allow for “alpha” opportunities for (some) active managers. Unfortunately, true “alpha” is not only difficult to obtain, but difficult to measure. In essence, alpha is defined as a source of return above what the market expects given its underlying risks. Alpha can only be obtained by skilled active management. By definition, the goal of achieving alpha is a zero-sum game. After fees and transaction costs are taken into account, the performance of active managers in aggregate are far worse off than those of passive funds tied to various market benchmarks.
One reason why alpha is difficult to measure is the difficulty in defining our “market portfolio.” For the large cap equity manager, a market portfolio could be the S&P 500 or the Russell 1000. But what about hedge funds that invest in CDOs, or private equity funds that invest in distressed debt or middle market firms? For a large university endowment (>$1 billion), a market portfolio is even more difficult to measure. For example – in creating a global portfolio consisting of all possible asset classes – how do we account for the market value of commodities? If we tally up the amount of recoverable reserves at market prices, we are ignoring the fact that much of this value has already been captured by the value of many integrated oil or global mining companies. Robert Litterman, a Managing Director at Goldman Sachs and Chairman of Goldman Sachs Asset Management (GSAM) suggests one possible way, which we discussed in our May 15, 2008 commentary.
Another reason why alpha is difficult to measure is the very high monitoring costs and for a lack of a better term, intellectual laziness. For example, hedge fund and mutual fund managers alike can easily “goose up” their returns without much additional risk by investing in less mainstream and out-of-benchmark asset classes and label those returns as “alpha,” even though technically, these excess returns should be labeled as “exotic beta” (which we will get to in a moment). Another strategy may involve buying the securities on leverage or buying high yield or high beta stocks within a traditional bond or stock portfolio. Still another strategy may involve buying stocks that have benefited from the tremendous increase of leverage within the global economy in the last 60 years, such as (before 2007) credit card companies, subprime originators, major casino operators, casual diners, consumer durables, and auto stocks (mainly in Toyota and Honda). Excess returns obtained from these last two strategies of buying securities on leverage or securities that benefit from an increase in economic leverage are what I would label “levered beta.” For a hedge fund manager who charges “two-and-twenty” and who is focused on quarterly performance, these strategies are infinitely more attractive than a strategy based on pure stock picking or market timing. At the very least, such a strategy would allow the hedge fund manager to spend time on his favorite hobby – whether it is on his wine/exotic car collection, or flying to see the Final Four game on his own private jet! For a fixed income manager, such a strategies (e.g. buying emerging market debt over the last few years) could have easily added an incremental annual rate of return of 25 to 50 basis points.
The following chart shows what MarketThoughts.com believes are the basic “building blocks” of returns for the typical institutional (e.g. pension funds, endowments, and foundations) or ultra high net worth individual:
There are two reasons why we chose to encompass the strategy of buying “high beta” stocks into the much broader “levered beta” strategy. Firstly, it has been empirically shown that stocks with high betas do not have higher returns. But this definition of high beta is retrospective only. In other words, stocks with higher betas should, in theory, have higher returns if these stocks and the concept of “higher betas” are categorized and defined correctly. To avoid confusion, we label this strategy as a “levered beta” strategy as opposed to a “high beta” strategy. For example, in a bull market for equities, buying a diversified portfolio of stocks with leverage should result in excess returns over the market over time. This is the crudest form of a levered beta strategy. A more developed form would involve selectively buying companies with highly leveraged balance sheets. This is primarily the strategy of the Fidelity Leveraged Company Stock Fund. As shown by the performance of the fund since 2003, this fund has outperformed the S&P 500 dramatically from 2003 to 2007, only to crash and burn last year as the credit crisis and deleveraging hit the financial market with full force. In other words, the fund's excess returns from 2003 to 2007 were simply levered beta masquerading as alpha (as an aside, these folks should have known better).
A more refined levered beta strategy involves buying securities that would benefit from an increase in the underlying leverage of consumers and corporations within the global economy. Ever since the end of World War II, the amount of leverage within the global economic system has grown steadily, as a result of a general temper of the business cycle and the rise of the two-income household. Manifestations of this secular trend include a rise (as a proportion of households' budgets) in consumer discretionary spending, a rise in the debt-to-equity ratio of US households, and a corresponding emergence/growth of various industries that cater to this new “consumer culture,” such as the credit card industry, the casual dining industry, the luxury retail industry, the global auto industry, and the major casino operators. As I implied in our last weekend's commentary, buying a house in Las Vegas or buying the major casino operator stocks were simply part of a levered beta strategy – a levered beta strategy that has worked well since the 1970s but which have already come to a dramatic close. There was no special genius involved. The only true alpha generators within Las Vegas or the casino industry over the last 30 to 40 years were folks like Kirk Kerkorian and Steve Wynn.
Exotic beta, on the other hand, involves a relatively or strictly passive exposure to risk factors or asset classes that are expected to produce returns above the “equilibrium level.” As discussed by Robert Litterman, this usually involves buying securities in asset classes that are less mainstream (i.e. where many institutional investors do not operate in). This may involve buying microcap stocks (this typically favors the shrewd retail investors than the institutional investor, given the lack of liquidity in microcap stocks), foreign small cap equities, emerging market bonds, distressed debt, foreign real estate, or private equity. Since these asset classes are less mainstream, it is also much easier to extract alpha from these strategies. As US economy continues to deleverage in the next few years, and as the global financial markets continue to mature, I expect institutional and high net worth individuals alike to continue to migrate towards these “exotic beta” strategies.
Over the next three to nine months, I expect levered beta strategies to enjoy a significant bounce, as global policy makers try to halt the deleveraging process with both fiscal spending and quantitative easing policies (the latter has already been taken up by the UK, the US, and Japan). I expect financial stocks, distressed debt, high yield bonds, and consumer discretionary stocks to outperform the rest of the market on a risk-adjusted basis, similar to the nine-month rally by technology stocks after the 2000 to 2002 bear market. Starting in 2010, I expect levered beta strategies to underperform, as the US and most of the developed world continues to rebuild their balance sheets. On the other hand, I expect technology and healthcare stocks to outperform, and for active managers to continue to move into “exotic beta” strategies (to try to extract alpha) including private equity, private real estate, foreign small caps, and emerging market bonds.
In the meantime, I expect the market to continue its rally over the next few weeks, as Tim Geithner provides more details of the Public-Private Investment Fund (PPIF) this Monday. As I discussed last week, my sense is that the ABX indices have hit an important low. Over the next few weeks, I expect the ABX indices to move higher and for CDS spreads to narrow as private investors flood back into the asset-backed security market. But there is no time to lose. Moreover, until the Obama administration finds a more forceful way to stabilize the housing market, there is always a danger of more deleveraging and a resumption of the bear market in risky assets further down the road. For now, we remain 125% long in our DJIA Timing System.
Let us now discuss the most recent action in the U.S. stock market via the Dow Theory. Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown by the following chart from July 2006 to the present:
For the week ending March 20, 2009, the Dow Industrials rose 54.40 points while the Dow Transports rose 97.90 points. There was no surprise here, as we had expected that the market will consolidate after the DJIA's 597-point rise the week before. The two Dow indices have now risen two weeks in a row. While they are still below their most recent resistance levels, the rally in the last two weeks was certainly nothing to sneeze at, as both upside breadth and upside volume was at their most impressive levels so far in this bear market. More importantly, the Dow Transports managed to hold above its March 2003 lows at its lowest level – suggesting that the global economy is still holding up relatively well (and as confirmed by the recent rally in commodity prices). Given the cheapest valuations in over 25 years, the many positive divergences we have discussed, and the inevitable fund flows into equities due to institutional rebalancing and the thawing of the credit system as the Fed and Treasury move in with the TALF and the soon-to-be-announced PPIF, I expect the rally to develop some legs over the next several weeks to several months. Should there be any further need for capital, I continue to expect the US Treasury to stand by the terms of its February 10th “Financial Stability” plan, and once further clarity is provided on the PPIF, I also a significant increase in bank lending. Because of this, we will maintain our 125% long position in our DJIA Timing System.
I will now continue our commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys. The latest four-week moving average of these sentiment indicators rose from a historically oversold reading of -26.8% to –24.0% for the week ending March 20, 2009. Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 1997 to the present week:
Assuming that the four-week moving average of our sentiment indicators has reversed to the upside, there is a very good chance the market will continue to rally, as the most bullish signal has typically occurred when sentiment indicators such as this reverses from a historically oversold level. Moreover, one of its components, the AAII Bears reading, spiked to a whopping 70% three weeks ago, which is the most bearish reading since the survey began in 1987. With the US Treasury preparing to provide more clarifications on the PPIF on Monday, and coupled with the inevitable rebalancing into equities by institutional investors, my sense is that the market could sustain its rally over the next several weeks to several months. Given the very attractive global equity market valuations, the sheer amount of global investable capital sitting on the sidelines, and the easing in the money/credit markets, we are now more bullish than at any time since late 2002/early 2003.
I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index. For newer subscribers, I want to again provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator going forward. Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.
When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls. As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms. This makes the indicator a perfect contrarian indicator for the stock market. Since the inception of this index during early 2002, its track record has been one of the best relative to that of other sentiment indicators. Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from May 1, 2002 to the present:
Since its most recent low on February 4th, the 20 DMA has bounced back up to a 10-week high reading of 135.1. While this sentiment indicator is now trading at a level that is overbought relative to its readings over the last two years, it is still somewhat oversold relative to its longer-term readings. More importantly, the 20 DMA is now trading authoritatively above its 50 DMA – suggesting that both bullish sentiment and the stock market are now biased towards the upside. As a result, the ISE Sentiment reading is also supportive for a sustainable rally in the stock market over the next several weeks to several months. Assuming that the US Treasury clarifies its PPIF plan on Monday equities should have already bottomed last week. As I have mentioned in a previous commentary, as long as one is under the age of 60 and is in a reasonable state of health, I believe US equities are a once-in-a-generation buy at current levels.
Conclusion: The financial and economic crisis over the last 18 months requires a “rethink” in every portfolio's sources of return – starting with what is truly alpha and what is levered beta or exotic beta masquerading as alpha. For those who are still invested in active large cap or traditional fixed income funds, one should seriously think about these funds' competitive advantages, especially if they underperformed their benchmarks last year. As the financial markets continue to mature, the chances of finding true alpha within a traditional fixed income or large cap equity portfolio will tend to zero. Case in point: The PIMCO Total Return Fund (Institutional shares), the number one ranked traditional fixed income fund over the last ten years, beat its benchmark by only 0.74% on an annualized basis. If PIMCO – a world-class investment institution with a direct line into the Federal Reserve, the US Treasury, and countless finance ministers in other major countries – could only manage an outperformance of 74 basis points a year, what chance do other managers have over the long run?
In the meantime, I expect levered beta strategies to come back into vogue as global policy makers go “all out” to cushion or stop the deleveraging in the financial markets. Consequently, I expect financial stocks, consumer discretionary stocks, high yield bonds, and distressed debt to outperform all other asset classes on a risk-adjusted basis for the next three to nine months. Starting in 2010, however, this trend should change yet again, as consumers and corporations around the world start to rebuild their balance sheets once again. Whatever future growth we achieve will need to come mostly from Schumpeterian growth, while true alpha would mostly be extracted from “exotic beta” strategies such as microcap stocks, foreign small cap stocks, private equity, and private real estate strategies. As the US Treasury and the Fed continue to find ways to reliquify the asset-backed markets and our financial institutions (through the Fed's stress tests), I expect CDS spreads to narrow and for the structured finance indices to start their recovery. Such a scenario would not only benefit the asset-backed markets, but the stock and bond markets as well (especially the balance sheets of major financial institutions). With the darkest sentiment in decades and the sheer amount of capital on the sidelines, we have decided to “break with tradition” and go to a 125% long position in our DJIA Timing System on February 24th. We will sell this additional 25% long position once the market rally starts to lose steam. For those with a long-term timeframe, the stock market still represents one of the best buying opportunities of our generation. Subscribers please stay tuned.
Henry To, CFA