Looking at the world through a , Morgan Stanley’s Brian Hayes sees potentially lower returns ahead for the stock market and there is including equity market neutral and event driven strategies. Monitoring key spreads, and using free cash flow as a metric, he and his team determine that low growth stocks might be favored in the year ahead.
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Why has alpha been such an factor for professional investors such as equity market neutral and other fundamental hedge fund ?
Morgan Stanley looks at the usual suspects – repressive central bank policies and passive investing – to find the answer. While these may be contributing factors, something more is afoot.
In a September 28 report titled ‘The Great Compression,’ Hayes and his mathematical team look at the issue from a different perspective and ask: ‘It is natural to ask whether low valuation spreads are contributing to diminished alpha generation?’
Since January 2013, alpha generation has ‘generally been modest,’ as the HFRX Equity Hedge index had a cumulative alpha of 3.8% over the period. The HFRX Equity Market Neutral Index, a quant equity proxy, delivered just 2% of alpha.
‘These data points are in line with anecdotal evidence of equity investors having difficulty generating alpha in the past few years,’ Morgan Stanley pointed out. ‘Lackluster alpha (along with strong and low-volatility market returns) likely have contributed to the growth in passive investing.’
Spreads are often a differential benchmark that provides investors opportunity. A wide spread between correlated assets can present an opportunity for a number of fundamental and strategies. But when spreads are tight, an opportunity might also contract as well.
But that is not the only place where tighter spreads are having an impact. It could also mean different stock picking metrics might become more accurate at generating opportunity.
To understand where value lies, Morgan Stanley’s quantitative equity research team studied ten valuation and growth metrics: trailing and forward earnings yield, book to price, sales to price, dividend yield, free cash flow yield, FY2/FY1 earnings growth, FY1 and FY2 earnings estimate dispersion and long-term growth rate expectations.
Applying these across various stocks, they noted that the spread between ‘cheap’ and ‘expensive’ stocks, which also applies to fast-growing and slow growing stocks, is relatively narrow when compared to a statistical analysis dating back to 1978. The only area where the spread didn’t narrow on a relative basis was with long-term growth expectations.
This narrowing of spreads has many implications which are dependent on the investor type and indicator.
Low dispersion in yield, for instance, is pointing to ‘year-ahead returns will be modest for several equity strategies,’ the report noted. But that wide dispersion in long-term growth rates could be pointing to a strong market environment for low growth stocks.
Morgan Stanley points to dividend yields only being 52 basis points wide across the middle 20% of stocks, but 1.7% wide across the middle 50% of stocks. For fundamental investors, they say compact valuations mean that they should look at factors other than value and growth when considering stock selection.
For quantitative investors, the picture changes slightly.
‘Compressed spreads are a modest negative for the future efficacy of valuation and growth factors,’ the report pointed out, looking at positive correlations between future 12 month valuation factor performance. ‘Valuation factor performance improves with increased spreads,’ they noted, adding the caveat that such improvement does not occur in a significant way.
Going forward, the low spread differentials could negatively impact certain hedge fund strategies, such as fundamental long / short equity, equity market neutral and event driven strategies, the report said.