Elusive in 2016, Alpha Could Return and Reward Patient Investors INVESTMENT IN BRIEF While equity markets performed well against an uncertain backdrop in 2016, active managers largely struggled. We observed that lower-quality and unprofitable companies generally outperformed the market last year, particularly after the US election. We expect this rally to fade and companies with strong underlying fundamentals to outperform over time. While elusive in 2016, investors will need alpha in the future, as we re likely to experience rising volatility, more uncertainty and lower returns. The S&P 500 Index finished 2016 up nearly 12%, an impressive feat given last year s bearish early mood, rising populist sentiment around the globe and plenty of uncertainty sprinkled in. The index got off to its worst-ever start through mid-february but rallied sharply, even after the surprising leave vote for Brexit, Italy s rejection of constitutional reform and the unexpected win by Donald J. Trump in the US presidential election. But while markets were resilient in 2016, active managers largely struggled against this backdrop. In the US large-cap growth universe, for example, 92% of active managers lagged the benchmark. Other styles also underperformed 75% of US large-cap core, 78% of large-cap value and 74% of mid-cap growth managers underperformed. Alpha was elusive in a historic way. 1 What happened? We took a deeper look at 2016 equity returns and found that lower-quality and unprofitable companies outperformed the market overall. The unexpected Trump win, in particular, stoked a strong momentum rally that lifted most stocks, but some areas of the market benefited more than others. Value outperformed growth, cyclical stocks overtook secular and high-quality names generally underperformed riskier, higher-beta stocks, for example. When disaggregating these returns, we observed that there was more at play than the headlines suggested. Despite a challenging 2016, we believe patient investors will continue to benefit from alpha over the long term. And they will need outperformance more than ever, as many capital market forecast assumptions predict that lower asset returns are on the horizon. 2 Below is a look at some of the factors at play in the recent momentum rally, along with a peek ahead at what investors might expect for equity markets in the short and medium term. page 1 of 5
The market s unexpected lift After getting off to a poor start in 2016, the US equity market rallied into positive territory as worries about China faded, underlying economic data generally improved and corporate earnings rebounded. Headlines about Brexit, Italy and the continued slow pace of global economic growth failed to dim rising optimism. And then Trump happened pushing positive market sentiment into outright euphoria as investors bought into a new narrative centered on the return of growth, lower taxes and less business regulation, among other factors. The market s mood swing was evident by the number of short sellers who were active early in the year but then reversed course toward the end, when the Trump rally gained steam, as shown in Exhibit 1. Exhibit 1: Short interest collapsed in 2016 Number of shares Short-interest declined 20% in 2016 as equities rallied 19B 18B 17B 16B 15B 14B 13B 12B 11B NYSE Short Interest (lhs) S&P 500 (rhs) 2007 2008 2009 2010 2011 2012 2013 2014 Source: FactSet, S&P. MFS, data is monthly as of 30 December 2016. 2015 2,400 2,200 2,000 1,800 1,600 1,400 1,200 1,000 800 600 2016 S&P 500 Index level The amount of short interest in a particular stock is one gauge for determining the quality of a company. Investors, mostly hedge funds, short-sell the stocks of companies they view as lowerquality, overpriced and fundamentally flawed, and seek to profit from falling prices. With the help of a third party, we examined the returns of all companies in the S&P 500 Index that were shorted in 2016 to see how their performance compared to the broad market. 3 These stocks should theoretically have lagged the market, but the entire group outperformed the S&P 500 Index last year by over 330 basis points. What s more, the most heavily shorted stocks (when disaggregated into quintiles) returned 21.5%, as shown in Exhibit 2. All but the second quintile, which returned 11.1%, outperformed the market as measured by the S&P 500 Index. Exhibit 2: Shorted stocks mostly outperformed the market in 2016 25% S&P 500 Index 2016 Performance by Short-Interest Quintile 20% 21.5% 2016 Returns 15% 10% 11.1% 12.8% 15.8% 15.5% 12.0% 5% 0% Quintile 1 Quintile 2 Quintile 3 Quintile 4 Quintile 5 S&P 500 Source: Strategas Research Partners, as of 30 December 2016. The graph displays all shorted stocks in the S&P 500 Index from 2016 broken down into quintiles, with Quintile 1 showing the most-heavily shorted stocks and quintile 5 showing the least shorted stocks. Please see the end of the article for definitions of short-interest and other terminology. page 2 of 5
Unprofitable companies also outperformed in 2016 If shorted and cheap stocks were last year s winners, then how did stocks of unprofitable companies perform? We ran a test to see. Using trailing 12-month earnings, we disaggregated the market return between profitable and unprofitable companies. We aggregated the returns of each universe and found that the negative earners returned 15.5% last year, about 350 basis points higher than the broader market as represented by the S&P 500 Index. Profitable companies lagged the index. Looking at the universe by price/earnings multiples, the lowest P/E quintile outperformed the highest by 19 percentage points in 2016, showing just how strong a factor valuation was last year. 4 Why would unprofitable companies perform so well? Directionally, it makes sense, given last year s sudden reversal from bearish to euphoric sentiment, when viewed in the context of an asset pricing model. In an asset pricing model, securities can be viewed as either cheap or expensive relative to a risk-free rate, such as US Treasury bills. In the aftermath of the Trump election, lower-quality securities were given a boost on the new narrative that pro-growth policies and a businessfriendly agenda could help the future results of companies more than previously thought. Stronger growth and rising inflation should also lead to higher interest rates, including a higher risk-free rate, which means companies with higher expected future cash flows would be less attractive in this type of environment. This points to the move in stock price leadership that was experienced post-trump (e.g., value over growth; cyclicals over secular stocks). The move directionally made sense, although we believe the magnitude of the price swings were excessive, as is usually the case during a strong momentum rally. Markets tend to overreact and underreact to short-term developments, which is why keeping a long-term view is so important for investors. Active conditions look better While 2016 was a difficult year for most active managers, it was also a year where more market inefficiencies were created not fewer. Equity correlations recently fell to a 10-year low, creating better conditions for active managers, as shown in Exhibit 3. When individual stocks are less correlated to each other, it means prices are less sensitive to macro events such as elections and interest rate moves and more responsive to underlying company fundamentals such as earnings and free cash flow. We expect businesses with competitive advantages, differentiated products and services, long-term margin sustainability and cross-cycle compounding of free cash flow to outperform over time. Exhibit 3: Equity correlations have fallen 20% since September 0.9 0.8 Correlation coefficient 0.7 0.6 0.5 0.4 0.3 2010 2011 2012 2013 Source: Strategas Research Partners. Data shows rolling 65-day correlations of S&P 500 stock, 2010-1/24/2017. A correlation of 1.0 indicates that all stocks moved either up or down in lockstep with each other. 2014 2015 2016 2017 page 3 of 5
Why alpha matters now more than ever If a stock/bond balanced investor were to dream the optimal investment climate for the last 30 years, this period would have exceeded it. Since 1980, the US equity market has returned 11.4% annually, compared to a long-term historical average of 8.8%, while US government bonds have returned 8.2% annually, versus a 4.7% historical average. 5 Elevated asset returns were further augmented by relatively low volatility and by a negative correlation between stocks and bonds a rare occurrence in financial markets for more than a century. Risk-adjusted returns like these may never be seen again in our professional lifetime. We believe these conditions are unlikely to continue, which means identifying the outperformers while reducing exposure to the underperformers will matter more. The value of active, like markets, is cyclical. Active has less value when backdrops are forgiving and when missteps and mistakes by corporations aren t punished. In our experience, the value of active increases dramatically when volatility spikes and fundamentals good and bad reassert themselves in asset prices. Author Robert M. Almeida, Jr. Institutional Equity Portfolio Manager TERMINOLOGY Alpha is a measure of the portfolio s risk-adjusted performance. When compared to the portfolio s beta, a positive alpha indicates better-than-expected portfolio performance and a negative alpha worse-than-expected portfolio performance. Beta is a measure of the volatility of a portfolio relative to the overall market. A beta less than 1.0 indicates lower risk than the market; a beta greater than 1.0 indicates higher risk than the market. It is most reliable as a risk measure when the return fluctuations of the portfolio are highly correlated with the return fluctuations of the index chosen to represent the market. Correlation measures the degree to which two securities, or two asset classes (such as stocks and bonds), move in relation to each other. The value is a calculation known as the correlation coefficient, which falls between -1 and 1. Assets that have a correlation of 1 move in perfect lockstep together all the time, either positive or negative, while a -1 correlation means two assets move in opposite directions. A correlation of 0 means there is no relationship between the two. Short-interest measures the quantity of stocks that investors have sold short (borrowed) but have not yet covered (positions are open). Short interest is measured by dividing the number of shares sold short by the total number of outstanding shares. It is used as a sentiment indicator - rising short interest means investors are becoming bearish on a particular security. Short-selling is when an investor seeks to profit from a security that declines in price. Short-sellers borrow shares, sell them and seek to re-buy the same shares later at a lower price and pocket the difference as profit. Short-sellers gain on price declines, but lose when shorted stocks rise in value. page 4 of 5
Endnotes 1 Source: Bank of America Merrill Lynch, data as of 30 December 2016. 2 See for example; McKinsey Global Institute, Diminishing Returns: Why Investors May Need to Lower Their Expectations, May 2016, and Callan Institute, Risky Business, September 2016. 3 Strategas Research Partners, as of 30 December 2016. 4 Bank of America Merrill Lynch, data as of 30 December 2016. 5 AllianceBernstein, Global Quantitative Strategy: Declining Returns and Diminished Diversification: The Great Challenge for Investors, January 2017. Keep in mind that all investments carry a certain amount of risk including the possible loss of the principal amount invested. The views expressed are those of the author(s) and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice from the Advisor. Unless otherwise indicated, logos and product and service names are trademarks of MFS and its affiliates and may be registered in certain countries. Issued in the United States by MFS Institutional Advisors, Inc. ( MFSI ) and MFS Investment Management. Issued in Canada by MFS Investment Management Canada Limited. No securities commission or similar regulatory authority in Canada has reviewed this communication. Issued in the United Kingdom by MFS International (U.K.) Limited ( MIL UK ), a private limited company registered in England and Wales with the company number 03062718, and authorized and regulated in the conduct of investment business by the U.K. Financial Conduct Authority. MIL UK, an indirect subsidiary of MFS, has its registered offi ce at One Carter Lane, London, EC4V 5ER UK and provides products and investment services to institutional investors globally. This material shall not be circulated or distributed to any person other than to professional investors (as permitted by local regulations) and should not be relied upon or distributed to persons where such reliance or distribution would be contrary to local regulation. Issued in Hong Kong by MFS International (Hong Kong) Limited ( MIL HK ), a private limited company licensed and regulated by the Hong Kong Securities and Futures Commission (the SFC ). MIL HK is a wholly-owned, indirect subsidiary of Massachusetts Financial Services Company, a U.S.-based investment advisor and fund sponsor registered with the U.S. Securities and Exchange Commission. MIL HK is approved to engage in dealing in securities and asset management-regulated activities and may provide certain investment services to professional investors as defi ned in the Securities and Futures Ordinance ( SFO ). Issued in Singapore by MFS International Singapore Pte. Ltd., a private limited company registered in Singapore with the company number 201228809M, and further licensed and regulated by the Monetary Authority of Singapore. Issued in Latin America by MFS International Ltd. For investors in Australia: MFSI and MIL UK are exempt from the requirement to hold an Australian fi nancial services licence under the Corporations Act 2001 in respect of the fi nancial services they provide to Australian wholesale investors. MFS International Australia Pty Ltd ( MFS Australia ) holds an Australian fi nancial services licence number 485343. In Australia and New Zealand: MFSI is regulated by the SEC under US laws and MIL UK is regulated by the UK Financial Conduct Authority under UK laws, which differ from Australian and New Zealand laws. MFS Australia is regulated by the Australian Securities and Investments Commission. MFSE-ELUSIVE-NL-2/17 37361.1