Tag Archives: investing ideas

Evaluating Alternatives In 4 Growth And Inflation Scenarios

By DailyAlts Staff Alternative strategies aren’t a homogeneous bunch. Due to their generally unbenchmarked nature, alternative funds within the same category can vary greatly in terms of their objectives, strategies, and risk/return characteristics, to say nothing of the wide diversity of funds and strategies across the universe of alternative styles. In a new white paper titled ” Alternatives in action: A guide to strategies for portfolio diversification ,” Putnam Investments’ Christian Galipeau, Brendan Murray, and Seamus Young set out to answer two questions: What are reasonable performance expectations for alternative investment strategies? How can these strategies fit into a portfolio of traditional assets? For their study, they looked at four alternative categories over the past 20 years, breaking those categories down into sub-styles where appropriate. Their findings: Not surprisingly, different strategies have performed better under different economic scenarios, but funds from the “Risk Reducer/Volatility Dampener” category – such as multi-strategy and global macro funds – have had the most consistent risk-adjusted returns over the past two decades. Classification of Styles For purposes of their analysis, the Putnam Investments authors break alternatives into four broad categories: Return Enhancers Inflation Hedges Risk Reducer/Volatility Dampeners Zero Beta/Zero Correlation The authors then look at how each category has performed under various economic environments over the past 20 years. For the Return Enhancers category, they look at the performance of the Cambridge Associates US PE Index as a proxy for private equity (“PE”). For Inflation Hedges, their benchmark is the S&P GSCI Gold Index Total Returns, as a proxy for precious metals. The Risk Reducer/Volatility Dampeners and Zero Beta/Zero Correlation categories are split into two and three sub-styles, respectively. The former includes multi-strategy and global macro funds, as measured by the Credit Suisse Hedge Fund Index for each style; and the latter includes managed futures, market neutral, and convertible arbitrage funds, also represented by Credit Suisse benchmarks. Future Economic Scenarios “Understanding how different alternative strategies may behave in different environments is essential to utilizing alternatives as an effective source of diversification over market cycles,” the authors write. They look at the performance of each style and sub-style over the period from 1994 to 2013, across four economic scenarios [Growth (G) / Inflation (I)]: G+/I+: Above-trend economic growth with above-trend inflation. G+/I-: Above-trend economic growth with below-trend inflation. G-/I+: Below-trend economic growth with above-trend inflation. G-/I-: Below-trend economic growth with below-trend inflation. As shown in the image above, “G+/I+” has been the most common scenario over the 20 years ending with 2013, but it isn’t necessarily likely to be the most common over the next 20. Performance Under Different Cycles Global macro funds provided the best risk-adjusted returns under G+/I+, G-/I+, and G-/I- scenarios – only the rare and unlikely G+/I- (high growth/low inflation) scenario did another style outperform global macro on a risk-adjusted basis, in this case private equity. The image below shows the risk-adjusted returns of all the strategies under review, as well as traditional assets, over the 20 years ending in 2013: But when using alternatives within a portfolio, another important consideration is how the strategies correlate with other assets in the portfolio. Not surprisingly, the Zero Beta/Zero Correlation sub-styles performed best in these terms, with market neutral funds having the lowest equity beta and correlation under the G+/I+ scenario, and managed futures earning that distinction under G-/I+ and G-/I- scenarios. In closing, the authors state that their study confirms that “alternative strategies can represent valuable innovations to the toolbox of portfolio choices.” Further, “in specific types of economic periods, the performance of some alternatives can diverge from their long-term characteristics.”

Time To Bring Active Back Into A Portfolio?

The U.S. stock market has advanced steadily over the past six years, a rally fueled partly by unusually accommodative monetary policy and notable for its near absence of volatility. But while stocks in general have rallied since the economic recovery began to take hold in 2009, many active portfolio managers have struggled to deliver investor returns in excess of the broader market, according to a BlackRock analysis of data accessible via Bloomberg. Many factors have been cited for this persistent underperformance , including higher fees and risk aversion in the aftermath of the financial crisis. However, another contributing factor has arguably been the Fed’s extraordinarily easy monetary policy suppressing volatility and hindering active managers’ ability to generate excess returns via security selection and portfolio tilts. Regardless of the cause, the value proposition of active management simply hasn’t materialized in recent years. However, with the Federal Reserve (Fed) poised to begin raising rates as early as next month , investors will have to adjust to more modest returns from U.S. stocks as well as brace for heightened volatility. This could create an opportunity for an active management approach. As Kurt Reiman and I write in our new Market Perspectives paper, ” A Quantum of Solace: Can the return of volatility revive active management “, we may be entering a more favorable environment for active manager performance. Based on our analysis using Bloomberg performance data for the S&P 500 Index back to the mid-1990s, there’s some evidence that managers’ ability to beat benchmarks comes in cycles. In fact, two somewhat interrelated variables do a reasonably good job of explaining the performance of active managers relative to their benchmarks: the annual change in volatility and the annual change in cross-sectional dispersion. (Cross-sectional dispersion measures the spread of asset returns or, in the case of the S&P 500 Index, the tendency of individual company returns to diverge from the average index return.) As the chart below shows, we found that periods of rising volatility and heightened cross-sectional dispersion coincided with manager outperformance in large-cap U.S. stocks. (click to enlarge) Looking forward, both volatility and cross-sectional dispersion are likely to eclipse the levels experienced in the past few years for large-cap U.S. stocks. This means that, in an environment where returns are harder to come by, investors may want to consider an active manager to source some returns and take idiosyncratic risk. That said, we’re not advocating that investors abandon the benchmark-replicating approach. With bull market and economic expansion more mature, blending active management exposures – whether through actively-managed exchange-traded funds (ETFs), multi-asset managers, traditional active equity managers or other sources – with benchmark-replicating vehicles will become increasingly important for meeting return objectives and controlling risk. The bottom line: The more muted return prospects for traditional assets from here and rocky road ahead warrant a more thoughtful approach to blending active and passive investing in a portfolio . Kurt Reiman, a Global Investment Strategist at BlackRock working with Chief Investment Strategist Russ Koesterich, contributed to this post. This post originally appeared on the BlackRock Blog.

Exelon Corp. Is A Buy

Summary EXC has a low beta which will help during potential market downturns. EXC underfunded pension liability offers a “negative earnings duration” which will benefit from rising rate environment. Forward dividend yield of 4.48% is supported by large dividend coverage ratio. Common shares are selling at a discount compared to historical valuations and peer group. Exelon Corp. (NYSE: EXC ) is a utility services holding company engaged in the energy generation and delivery business through its segments, Generation ComEd, PECO and BGE. According to the company’s website : Exelon’s family of companies represents every stage of the energy value chain. Exelon Generation is one of the largest competitive United States power generators, with approximately 32,000 megawatts of owned capacity comprising one of the nation’s cleanest, lowest-cost power generation fleets. Constellation provides energy products and services to more than 2 million residential, public sector and business customers, including more than two-thirds of the Fortune 100. And Exelon’s three utilities deliver electricity and natural gas to more than 7.8 million customers in central Maryland (BGE), northern Illinois (ComEd) and southeastern Pennsylvania (PECO).” Every day, we hear news about an impending stock market decline and an increase in interest rates. It was under this pretense that I went searching for companies that provide protection in both a rising interest rate environment and low beta stocks which could spare my portfolio in the event of a downturn. Low Beta The beta of a stock represents the systematic (market) risk of a company. When the beta is positive, the stock prices tend to move in the same direction as the market, and the magnitude of the Beta tells by how much. A stock beta greater than 1 implies that when the market goes up by 1%, we expect the stock to go up by more than 1% – the opposite is true if the market goes down by 1%. Utility companies are considered “Defensive” stocks because they typically have steady cash flows, attractive dividend yields and lower-than-average betas. Exelon is considered a “Diversified Utilities” company and has a lower-than-average beta of .24, compared to an average beta of .48 for all the “Diversified Utility” companies in the Russell 3000. All else being equal, we would expect to outperform its peer group in the event of a market downturn. Negative Earnings Duration What makes this sector especially enticing is that most of the firms have underfunded pensions, which represents a liability on the balance sheet. While that sounds ominous, it is quite common for older companies with pensions given the large amount of baby-boomers retiring today. In order to calculate the magnitude of the underfunded pension, you need to project out the future pension payments and discount them back at a specified rate of return, typically tied to the current interest rates. The difference in the pension liabilities is added or subtracted from earnings, depending on whether the liability is becoming smaller or larger. I like to call this “negative earnings duration” because the liability becomes smaller when you increase the discount rate (denominator). Duration measures the fall in price of a security given a 1% (parallel) rise in interest rates. In fixed income terms, we can say EXC has a negative earnings duration because earnings rise in a rising rate due the reduction in pension liability. Increasing interest rates reduce pension liabilities and increase earnings, all else equal. A quick glance at the magnitude of underfunded pensions in this sector makes EXC standout as an EPS beneficiary in a rising rate environment, given the size of its pension liability. On the Q3 conference call, Exelon management mentioned that every .25% rise in interest rates will lead to a .02 EPS increase. (click to enlarge) EXC selling at a discount compared to historical valuations and peer group Currently, EXC is selling below its 3 and 5 year price/earnings multiples, which could imply future mean reversion. Diversified utility companies typically have predictable cash flows and earnings due to the nature of the business and their hedging strategies. The charts below highlight the current PE multiple compared to its 3- and 5-year median as well as EXC quarterly earnings compared to analyst estimates. As expected, the actual earnings tend to oscillate around the estimates. (click to enlarge) (click to enlarge) Compared to its peer group, Exelon is selling at a discount by a nice margin based on PE multiples which implied that it is cheaper to own per share of earnings compared to its peer group: (click to enlarge) Dividend Coverage and Valuation Investors look to the utilities sector for dividends and EXC has not disappointed. The company has paid dividends consistently over the last 10 years and sports a healthy dividend coverage ratio. Dividend Cover is calculated by EPS/Common Dividends. For companies such as Exelon that are known to consistently pay dividends, taking a look at the dividend coverage ratio can be an effective way to see if dividend payments are being harder to make over time. Currently, dividend coverage is 1.816, which is healthy from historical perspective and makes the current dividend yield of 4.49% all the more attractive: (click to enlarge) When valuing EXC, we can look at the historical price earnings and price sales ratios for Exelon and its peer group over the last 20 years. From there, we can use the 2015 estimates for earnings and sales to derive a price for each and average the two together: Historical PE Multiple for EXC and Peer Group Average Median Blend 2015 EXC EPS estimate Price 1995-Present 22.9 16.2 19.55 2.5 48.875 Historical PS Multiple for EXC and Peer Group Average Median Blend 2015 EXC sales per share Price 1995-Present 1.5 1.23 1.365 28.11 38.37015 Source: Ycharts Blended price based on PS and PE 43.6258 Based on historical analysis, an intrinsic value of $43.62 represents a 58% upside from the current price ~$27.5 per share. Given EXC’s dividend coverage, low beta, (-) earnings duration and discount valuation, I believe it is a buy at these levels.