Long/short investing in financials: Tapping into an industry renaissance

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1 Andrew Heiskell Global Industry Analyst Long/short investing in financials: Tapping into an industry renaissance Matthew Scales, CFA Investment Director KEY POINTS We believe the global financials sector is well positioned for successful long/ short investing thanks to its ample breadth, history of high dispersion, and low intrasector correlation. In recent years, achieving long/short returns across a variety of capital-market sectors has proved more challenging. Looking ahead, initiatives such as the prospective unwinding of post-crisis policy accommodation by central banks and a more sensible approach to regulation and corporate tax policy in the US suggest a more fertile environment for long/short investing in financials. Improved conditions alone do not ensure investment success. Capitalizing on these conditions requires skill, particularly in a complex sector such as financials, making manager selection a critical decision. Over the last 20 years, the financial sector has been among the most volatile within global stock markets but with little risk-adjusted performance to show for it. A Sharpe ratio of a mere 0.1 for the sector (as proxied by the MSCI All Country World Financials Index) over the past two decades is a telling signal that simply buying and holding the beta has not been a great long-term strategy. All investors should consider the risks that may impact their capital, before investing. The value of your investment may become worth more or less than at the time of the original investment. Investors could encounter higher losses if their long and short exposures move in opposite directions at the same time and both in an unfavourable way. The financial sector has, however, shown the necessary ingredients to be attractive for long/short investing. Three of those ingredients are sector breadth, reasonable dispersion, and low intrasector correlations. Yet we believe these traits alone do not suffice and that manager skill is a fourth and critical ingredient to achieving sustained investment success. Given its complexity, investing in financial services companies can be a graveyard for generalist investors; but that same complexity can create fertile ground for specialists who have spent years or decades deepening their industry expertise. Since the global financial crisis (GFC), long/short returns across sectors have been below historical norms. But we think there are sound reasons to believe capital markets are transitioning to a regime better suited to long/ short investing across many sectors, including financials.

2 2 Wellington Management About the authors As a global industry analyst, Andrew covers the global life insurance, consumer/credit card, and specialty finance industries. In addition, he co-manages a financial services long/short strategy and manages global life, consumer, and mortgage finance subportfolios in research-based investment accounts. Matt is an investment director responsible for the business and investment oversight of certain alternative investment strategies managed by Wellington Management. Key ingredients As mentioned above, we believe there are four key elements that make a market segment ripe for potential alpha generation. Three of these ample breadth, high dispersion, and low correlation center on market conditions. We believe the fourth, manager skill, must be applied to those conditions in order to realize the potential alpha. We ll come back to skill later in the paper. Below we touch on the first three ingredients and how they relate to the financial sector. Breadth. The Fundamental Law of Active Management 2 states that a manager s information ratio is a function of both skill and the number of independent investment opportunities in that market. At a given skill level, the larger the number of opportunities, the higher the expected information ratio. Figure 1 uses the proportion of financial stocks in the MSCI All Country World Investable Market Index as a proxy for the sector s share of global equity markets. Figure 1 A broad opportunity set Number of stocks per sector, MSCI All-Country World Investable Market Index 1,600 1,400 1,459 1,389 1,200 1,149 1,000 1, Industrials Consumer discretionary Financials Technology Health care Materials Real estate Consumer staples Energy Utilities Telecommunication services Sources: S&P Dow Jones and MSCI, June As formulated by researchers Richard Grinold and Ronald Kahn in a series of articles published in the 1990s. There are approximately 8,600 names in the index, including over 1,100 financial stocks. Equity real estate investment trusts (REITs), carved out from the financial sector by MSCI in August 2016, are also typically considered part of the financial long/short manager s tool kit, making the proportion of investment opportunities in financials even greater. Extended further, Thomson Reuters estimates that as of June 2017 there were nearly 40,000 tradeable companies globally (excluding derivatives and multiple listings from the same issuer) of which more than 6,500 were financial and REIT stocks. In short, the financial sector has a significant amount of breadth, offering plenty of latitude to pick stocks, both good and bad, to capitalize on potential opportunities.

3 3 Wellington Management Dispersion refers to the variation of returns across securities within a given universe. The more dispersed the security-level returns within a sector, the greater the potential to capitalize on those price changes. Dispersion can be calculated in a number of ways. Figure 2 uses average annual returns of the top and bottom deciles of stocks in the MSCI ACWI Financials Index dating back to the start of 2007 a period spanning more than a decade. Figure 2 Ample dispersion in stock returns across the sector (%) Top-decile average return Bottom-decile average return YTD 2017 Financial sector proxied by the MSCI ACWI Financials Index. Year to date 2017 through June Past results are not necessarily indicative of future results Sources: MSCI, Wellington Management Remarkably, the average annual spread between the top and bottom deciles of financial stocks over this period has been over 100%! While the spread has narrowed more recently, we believe this dynamic has already begun to change, for reasons discussed later in the paper. The financial sector has a significant amount of breadth, offering plenty of latitude to pick stocks, both good and bad, to capitalize on potential opportunities.

4 4 Wellington Management Correlation measures the tendency of securities to move together or independently over time. In general, the lower the level of correlations within a universe, the better the conditions for stock picking. Figure 3 shows the average level of intrasector correlation within financials over the last 10-plus years. Following a roughly two-year period of rising correlations among financial stocks, those correlations have fallen sharply to more attractive levels. Figure 3 Falling cross-correlations of financial stocks Average correlations /07 6/08 6/09 6/10 6/11 6/12 6/13 6/14 6/15 6/16 6/17 Global financial stocks proxied by the MSCI Financial Index. Sources: MSCI, Wellington Management, January 2007 June 2017; correlation is calculated as the average of all crosscorrelations of all stocks within the sector, using monthly data observations. After rising for about two years, more recently correlations among financial stocks have fallen sharply to more attractive levels. Understanding the cause of the drop, and its potential to persist, is important. A fundamental shift for financial stocks Starting with Brexit in June 2016 and followed by the election of Donald Trump as US President in November 2016, it is clear that we are in a period of considerable global change. Within the US, markets have focused on several Trump administration priorities. Three of these deregulation, increased fiscal stimulus (with potential impact on economic growth and interest rates), and corporate tax reform are particularly relevant for financial stocks. We examine each of these in turn.

5 5 Wellington Management Deregulation Among the three Trump policy initiatives cited above, a less burdensome regulatory environment may have the greatest potential impact on financial stocks and, fortunately for investors in the sector, the least risk of falling victim to political gridlock. Figure 4 shows the relationship between commercial bank lending and deposits in the US. Figure 4 Capital sitting on the sidelines: Gauging the Tarullo Effect US$ Bil 12,000 11,000 10,000 9,000 Deposits, all commercial banks Loans and leases in bank credit, all commercial banks US$2.5 trillion 8,000 7,000 6,000 5,000 4,000 3,000 2, Data through June Shaded areas represent recessions. Source: Federal Reserve Recent turnover of influential officials in key regulatory agencies and other governing institutions provides tangible signs of a shift in the regulatory environment. Although bank lending and deposits were closely linked in the years leading up to the GFC, a gap of approximately US$2.5 trillion has opened between the two, with deposits far exceeding lending. This gap is often called the Tarullo Effect, a reference to Fed Governor Daniel Tarullo, who was widely regarded as a key driver of post-gfc regulation. While some of the shortfall may be attributable to lending activity by nonbank entities, we believe much of it is due to increased bank capital requirements as a result of post-gfc regulation. This excess capital has been sitting at the Federal Reserve earning basis points instead of being returned to shareholders or stimulating economic growth through loans to businesses and households. Policymakers seem to have taken note of the drag this underutilization of capital is imposing on the US economy. Recent turnover of influential officials in key regulatory agencies and other governing institutions provides tangible signs of a shift in the regulatory environment. In February 2017, Tarullo announced he would resign from his post. Two days before Tarullo s resignation came that of Federal Reserve General Counsel Scott Alvarez, whom many regard as the decisive voice in implementing Dodd-Frank, the most important piece of US post-gfc financial legislation. This changing of the guard opens the door to new officials with a fresh perspective on regulation of the financial industry.

6 6 Wellington Management In June 2017, the US Treasury released a report proposing a sweeping overhaul of the banking regulatory framework, one aimed at creating greater flexibility in bank capital requirements. While it remains to be seen how much of what was proposed will materialize, the report provides further evidence that the current administration is focused on a more pragmatic approach to regulation. Fiscal stimulus and corporate tax reform will be more complex Passing a fiscal stimulus package requires Congressional approval, which is proving to be a more complex proposition given the charged US political environment. The light blue line in Figure 5 shows the level of interest rates as measured by the fed funds effective rate at each year end from 1953 through As measured by the right-hand axis, rates rose from below 3% in the early 1950s to an intra-year peak above 19% (not shown) before settling above 16% at the end of From that peak, rates began a downward trend over the next nearly 30 years, hitting rock bottom by the end of 2008 amid the depths of the global financial crisis. The dark blue line shows US bank net interest margins, which can be helpful in gauging the overall economic health of the banking industry. Figure 5 While higher rates are not a prerequisite to making money in the financial sector particularly if an investor is able to take both long and short positions the potential for a longstanding headwind to shift to a tailwind is encouraging. Watching for an interest-rate tailwind (%) US bank net interest margins (LHS) Federal funds effective rate (RHS) /53 12/60 12/67 12/74 12/81 12/88 12/95 12/02 12/09 12/16 Sources: Federal Reserve, Federal Deposit Insurance Corporation (FDIC) As the chart shows, there appears to be a reasonably positive relationship between interest rates and bank net interest margins. While higher rates are not a prerequisite to making money in the financial sector particularly if an investor is able to take both long and short positions the potential for a long-standing headwind to shift to a tailwind is encouraging. We have seen some Fed action on policy rates already. With unemployment low, any fiscal developments aimed at improving trend economic growth also have the potential to put upward pressure on inflation and ultimately interest rates. In Europe, the European Central Bank (ECB) has begun to strategize on how it will unwind its quantitative easing program. We continue to closely watch these developments and their potential impact on markets

7 7 Wellington Management We expect these developments to drive a shift from a more homogenous market environment to one in which success or failure will again be determined by the quality of individual company management teams. Corporate tax reform The last major tax reform to be enacted in the US the Reagan-era Tax Reform Act of 1986 was passed with bipartisan support from both Democrats and Republicans. An already challenging legislative task seems likely to prove even more difficult in today s polarized political landscape. However, markets appear to have priced this in. So, any positive developments on tax reform should further support growth prospects broadly, and the normalization of interest rates specifically. New conditions call for a resetting of sector expectations We expect these developments to drive a shift from a more homogenous market environment to one in which success or failure will again be determined by the quality of individual company management teams. Hence, now may be the right time for investors to refresh their views of the financial sector. Our conviction is based on research we conducted. Drawing on data from evestment, we used median monthly returns for a universe of long/short financials managers 3 over a roughly 10-year period to create a hypothetical financial long/short return stream. We then calculated a rolling one-year return simulation to proxy how a typical financial long/short manager may have fared across various market conditions. In Figure 6, we overlay that simulation on the correlation chart from Figure 3. Correlation is now on an inverted scale to more clearly show its relationship to the performance of our simulated median long/short financial manager. Figure 6 Financials: intrasector correlations and median long/short manager performance 3 A custom universe was created from the evestment hedge-fund database using those managers whose sector focus was on financial services and whose investment focus was equity long/short. All returns used were net of fees Correlations of stocks in the MSCI ACWI Financials Index (LHS, inverted) 4 Simulated return of median financials long/ short manager rolling one-year (%, RHS) Global financial stocks proxied by the MSCI Financial Index; correlation is calculated as the average of all cross-correlations of all stocks within the sector, using monthly data observations. 5 Returns reflect a simulated financials long/short return stream based on the median monthly returns sourced from an evestment universe of actual long/short financials managers. The returns are not representative of any standalone portfolio or Wellington Management strategy. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. Simulated returns are for illustrative purposes only and are subject to numerous limitations including the benefit of hindsight. Assumptions were selected by Wellington Management and the use of a different universe of managers or time period would produce different results /07 6/08 6/09 6/10 6/11 6/12 6/13 6/14 6/15 6/16 6/17 Sources: evestment, MSCI, Wellington Management, May 2007 June 2017

8 8 Wellington Management Perhaps not surprisingly, performance of the median financials long/short simulation has been closely linked to the relative independence (or lack thereof) of stock price movements within the financial sector during this 10-year period. This brings us to the current market environment, in which correlations have fallen and sector returns are on the rise. While correlations have ebbed and flowed over this period, we believe there has been a fundamental shift in the underlying environment that should drive greater differentiation between good companies and bad in turn creating more opportunities for managers to take both long and short positions with the potential to generate attractive risk-adjusted returns. Manager skill matters Figure 7 shows the spread between the top- and bottom-performing financials long/short managers. From a very wide level during the GFC, this spread has since narrowed, troughing in 2014 and Yet even at its lowest level, the best-performing financials long/short manager in the evestment universe still outperformed the worst by 42%! Figure 7 A wide gap between top- and bottom-performing managers Annual return spread Maximum Minimum Median Max/min spread 105% 86% 51% 60% 53% 67% 42% 46% 75% Sample size Sources: evestment, Wellington Management 6 Reflects rolling one-year returns of a universe of long/short financials managers sourced from evestment and analyzed by Wellington Management. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. Using a different universe of managers or different time period would produce different results. Interestingly, only 14 managers were present in the evestment universe throughout the full period, of which 13 realized a Sharpe ratio of 0.5 or better after fees. This compares to a Sharpe ratio of 0.0 (zero) for the MSCI All Country World Finance Index over the same period. Conversely, almost half of the financial long/short managers in the evestment database in 2008 were absent from the 2016 data. These managers had ceased to populate the evestment universe, either by choice or through liquidation.

9 9 Wellington Management In our view, this speaks to the complex nature of financial companies and the challenges that face managers who may lack the depth and specialized skill to succeed in this sector over the long term. For those that did manage over the full period, the majority were able to generate attractive riskadjusted returns that may have been additive to virtually any portfolio. Waves of innovation are creating a sector rich in idiosyncratic opportunities. An industry in transition: Harnessing the investment potential of the financial sector Historically, the financial sector has not been known for its innovation or high-growth opportunities. We believe this perception is outdated. While interest rates and the health of global markets will continue to matter, new trends are pushing the industry beyond its traditional profile. Technology companies are reshaping consumer banking behavior. Data providers are becoming more important as data science increasingly drives financial firms decision making. India, a country of more than 1.3 billion people, is building a new financial infrastructure. Exchange-traded funds, robo-advisors, alternative strategies, and smart beta are changing the face of the asset management industry. These waves of innovation are creating a sector rich in idiosyncratic opportunities. We believe change is not only well underway, but is poised to accelerate as political regimes shift and conditions long constraining the sector, such as high regulation and low interest rates, abate. We believe a long/short approach can be a reasonable way to capitalize on these dynamics. A sector marked by significant breadth, ample dispersion, and increasing independence of returns among its individual companies provides favorable conditions for long/short approaches to potentially add value. In our view, applying deep and specialized skill is the critical final ingredient necessary to realize greater potential from this universe in the form of attractive risk-adjusted returns.

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