A team of Bank of America analysts are anticipating 0% returns to equities over the next decade. BofA’s head US equity and quant strategist Sativa Subramanian suggests investors brace themselves for a prolonged bear market. The bank’s long-term valuation model is forecasting a shocking -0.8% annualised return for the S&P 500 over the next ten years.
”This may not end now. But when it ends, it could end badly.”
— Subramanian Subramanian, Bank of America Head of US Equity & Quantitative Strategy
The analysts pointed to supply chain problems, peak globalisation and the squeeze of inflationary pressure as cause for concern. The BofA naysayers are not the only bears in town either. Although Wall Street remains neutral about US equities, the consensus is as close to a sell signal as it has been since 2007, Subramanian heeded. According to her team’s research, risk premia don’t adequately reflect the glaring supply chain risks and other global frictions.
BofA’s prescription for subdued capital gains is not particularly palatable either. Their only constructive advice is to hunt for yield. According to the bank’s estimates, dividend reinvestment could result in a paltry 36% total return over the next ten years — a mere 3.12% annualised return.
Following the dire warning, high-frequency trading fund PWE Capital published an insightful report highlighting what a sustained depression would mean for passive and active equity strategies. The PWE analysis explored correlations between numerous ETFs, Hedge Fund Indices, and Risk Premia.
Manas D. Kumaar, Group CEO of PWE Capital, was optimistic that hedge fund plays could save the day. However, the fund manager cautioned that investors would need to exercise more discretion in their selections going forward.
“A rising tide lifts all boats, but shallower waters will reveal what clings beneath the hull. Investors can no longer rely on central bank-fuelled long equity waves. Robust active strategies should reclaim their core value status by steadying the helm as investors tack through the wind.”
— Manas D. Kumaar, PWE Capital Group CEO
Additionally, PWE pointed out that BofA’s forecasts were expressed as absolute returns, which don’t account for the looming inflation risk. The PWE research heeded that if inflation runs hot, it could lead to further real yield erosion. BofA’s scenario assumes central banks manage to keep inflation below 2%. That arguably optimistic scenario implies a 1% real dividend yield and no capital gains.
As PWE acknowledged, it is easy to passively invest when the world is awash with central bank liquidity. “Going forward, most analysts would agree we are heading towards more turbulent waters,” Kumaar cautioned.
“A smooth sea never made for a skilled sailor. The coming decade will separate the beta from the true alpha. Those who fail to adapt now will not just miss the boat; they will sink.”
— Manas D. Kumaar, PWE Capital Group CEO
CORRELATION CONCERNS
The PWE research further assessed what a lost decade like the 1930s would mean for the fund management industry. It highlighted stark correlations between “the vast majority of equity hedge funds and stock market indices.” PWE attributes the lack of diversity to a herd mentality and culture of group-think on Wall Street. It also pointed to perverse incentives created by central bank profligacy. The analysts suggested it will “come as no surprise” if most equity hedge fund strategies face even more difficulties over the coming decade.
“What happens when markets finally wake up to the sobering reality that the central bank emperors have no clothes left to continue playing strip poker?”
— Manas D. Kumaar, PWE Capital Group CEO
To illustrate the point, PWE published a series of striking visualisations of the correlations between major asset classes and hedge fund indices over the past ten years.
The above correlation matrix heatmap from PWE Capital displays the alarming degree of co-movement between the majority of Eurekahedge hedge fund indices. In particular, the centre of the map shows a close-to-perfect correlation between the bulk of equity plays. PWE says the lack of diversity is problematic because correlations tend to increase even more dramatically during financial crises. The startling picture was reinforced by another striking graph, featured below.
An interactive version of the above Minimum Spanning Tree can be viewed in the original report. It depicts how most equity strategies are tightly clustered around the S&P 500 (represented by the SPY ETF). The notable outliers are currency, cryptocurrency, and to a lesser extent, trend-following strategies.
As PWE points out, Bitcoin and cryptocurrency hedge funds may be largely unrelated to the stock market. However, cryptocurrencies face “imminent regulatory threats.” Moreover, the Eurekahedge Cryptocurrency Index is 93% correlated with the price of Bitcoin, leaving it totally exposed to cryptocurrency fluctuations.
“If I wanted 90% exposure to Bitcoin, I would probably buy Bitcoin.”
— Manas D. Kumaar, PWE Capital Group CEO
On the other hand, traditional currency strategies displayed robust diversification benefits without the existential threat and stomach-churning volatility characteristic of cryptocurrencies. Furthermore, quantitative funds such as CTAs (commodity trading advisors) and trend-following strategies have also shown promise for their diversification strengths.
In stark contrast to BofA’s acceptance of meagre yields, PWE sees significant opportunity — not just for survival, but for exponential growth. That exponential growth opportunity, they claim, dwells in the depths of the global currency market. The currency market’s vast liquidity and low transaction fees make it attractive for modern quantitative strategies such as high-frequency trading. PWE Capital is one such high-frequency trading firm poised to prosper, regardless of market conditions. HFT and other direction-agnostic algorithmic tactics can consistently yield astonishing returns, with little to no correlation with broader markets.
PWE foresees a shift from equity-based strategies toward currency market plays. The fintech fund manager also anticipates a move from passive investing toward active approaches in general. The reason, Kumaar says, is because so-called smart-beta ETF products “may not seem so smart in future.” For example, the PWE CEO points to three iShares smart-beta ETFs; QUAL, SIZE, and VLUE. Over the past decade, each of those three ETFs has been over 90% correlated with the S&P 500.
“If Quality, Size, and Value factors are all over 90% correlated with the S&P 500, it begs the question, ‘How smart is smart-beta?’”
— Manas D. Kumaar, PWE Capital Group CEO
However, the analysts acknowledged one risk premium that their study might not have adequately represented — the momentum factor. For example, during the period under observation, since 2013, the iShares MSCI USA Momentum Factor ETF (MTUM) was 91% correlated with the S&P 500. However, momentum trading involves buying securities that have been rising and selling securities that have been falling. Therefore, momentum strategies will naturally have a higher beta during bull markets and conversely have an inverse correlation during bear markets.
The PWE analysis also noted how trend-following hedge funds and CTA funds were surprisingly unrelated to the iShares momentum ETF. The analysts suggested that rigid rules-based strategies employed by smart-beta products may not perform as well as their hedge fund counterparts when market conditions become choppy or stagnant.
Finally, the PWE report commented on the future of high-frequency currency trading. It alluded to the recent Bank for International Settlements paper entitled “Quantifying the high-frequency trading ‘arms race’.” PWE Capital stated that while they did not necessarily agree with the entirety of the report, the BIS commentary underscores the breadth of opportunities that exist for HFT in the currency market.
The BIS paper estimates that latency arbitrage generates $5 billion in profits each year in equity markets alone. The currency market is vastly broader than the stock market, with daily trading volume dwarfing all equity exchanges combined. The size of the FX market implies that HFT firms, particularly small-to-mid-size firms, can scale their assets under management without cannibalising their edge. As funds grow, it typically becomes increasingly difficult to execute trades without moving markets and becoming too cumbersome.
On the other hand, PWE acknowledges that high-frequency currency trading is not without its fair share of challenges. Unlike other securities traded on centralised exchanges, global currency transactions are conducted on a sprawling, fragmented, over-the-counter broker-dealer network. This lack of structure often incentivises opaque counterparty shenanigans, creating agency costs, moral hazard and other conflicts of interest. PWE Capital develops technologies to facilitate transparent high-frequency trading. Their in-house trading solution is intended to rectify some of the common problems facing HFT shops. Kumaar says their trading infrastructure not only affords them a speed advantage, but it also creates lucrative microeconomic benefits for them and their clients. The PWE approach puts them squarely in the driver’s seat. It facilitates transparency and empowers them with greater order flow control.
PWE sees such technological advancement as key going forward, not only for growth, but for survival. Kumaar envisions a future in which technology transforms the very essence of free-market capitalism. Considering both the tech and market structure opportunities, Kumaar says they remain quietly optimistic about the decade ahead.
The full PWE Capital report can be read here.
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About PWE Capital
PWE Capital is an Australian fintech company specialising in the development of technologies to facilitate high-frequency trading in the currency, commodities and derivatives markets.
