Indexology^® Blog

Today in the Wall Street Journal, there is an article, “Airlines Retreat on Fuel Hedging“, that highlights the losses airline companies suffered by hedging against oil and gas rises. However, the article also points out that not all airlines hedged, including American Airlines Group (NASDAQ: AAL), who enjoyed the benefit of cheaper fuel. Scott Kirby, president of AAL, was quoted, “hedging is just a rigged game that enriches Wall Street.”

Kudos to him and his shareholders for betting in the right direction. Not every commercial consumer (airline) made that choice, but the important point is that hedging against an oil price rise is a choice about managing risk. Hedging price risk to keep a company in business is not a Wall Street game, but it is possible Kirby was referring to Paul Cootner’s research from MIT in the 1960’s that explains commercial hedging as a highly specialized form of speculation.

In a letter to the FT, Hilary Till points out the futures markets exists to help companies specialize in risk taking by allowing them to use the basis risk, the difference between the spot and futures prices, to manage risk. This is helpful since the basis risk is more predictable than the commodity prices themselves. In the same article, Till points out Holbrook Working’s research from Stanford in the 1950’s showing that it is not necessarily precise daily correlation that matters for choosing a proxy hedge, but whether the proxy hedge provides a business with protection during a dramatic price move that could bankrupt a company.

However, not all companies are similarly vulnerable to bankruptcy from commodity price moves. The producers need protection against price drops more than commercial consumers need protection against price increases. So, the producers go short to protect against price drops and the consumers go long to protect against price increases, and the result is naturally more commercial shorts than longs.

This also true specifically in oil where there has been consistently more commercial short hedging than commercial long hedging.

The reason this is the case is supported by two economic theories: 1. Hicks’ theory of congenital weakness that argues it is easier for consumers to choose alternatives so they are less vulnerable to price increases than producers are to price drops, and 2. Keynes’ theory of “normal backwardation” that argues producers sell commodities in advance at a discount which causes downward price pressure, which converges to the spot at the time of delivery.

In the futures market, this gap needs to be filled between producers and commercial consumers that are hedging, opening the door for long commodity investors to earn a return called the insurance risk premium. This is illustrated by the bigger share of non-commercial longs than shorts.

This relationship is time tested and has remained stable as examined by Bhardwaj, Gorton and Rouwenhorst. They conclude although open interest has more than doubled for the average commodity since 2004, the composition of the open interest has remained remarkably stable.

Oil index investors that use long futures should be excited if all of the above holds true and airlines really are retreating on their hedging. The implication is that there may be a bigger risk premium to be earned as the net shorts grow (from the absence of airline long hedging.) The oil producers still hold more risk than commercial consumers and will likely pay investors to offset that risk. The timing may be perfect too with the signals that show oil may have bottomed. You can read about these two signals here and here.

More than a year ago, a number of commentators expressed confidence that 2015 would be the year when active equity management proved its value.  After all, the market had risen steadily for six years, and with stretched valuations, market volatility was likely to rise — creating opportunities for active managers to add value by skillful risk control.

This seems like a plausible theory — if only the facts had not conspired to rebut it.  Our SPIVA report for calendar 2015 shows that the majority of actively-managed U.S. mutual funds underperformed cap-weighted index benchmarks.  Similarly, the majority of large-cap institutional portfolios tracked in the eVestment database underperformed the S&P 500 Index.

Why was 2015 so difficult for active U.S. equity managers?  Answering this question requires us to distinguish between two oft-conflated concepts: the manager’s skill at stock selection or sector rotation, and the level of opportunity to demonstrate that skill.  Beyond observing that, in a market dominated by institutional players, the average manager cannot expect to outperform the market average, we have no particular insight into manager skill.  But opportunity can be measured systematically by the market’s dispersion, and dispersion in 2015, though slightly above 2014’s level, remained quite low by historical standards.

The level of a manager’s skill is independent of dispersion, but the value of his skill is dispersion-contingent.  The graph below illustrates this by reference to the interquartile range for large-cap U.S. managers in our SPIVA database.

The bars represent the difference between top quartile and bottom quartile managers or, crudely speaking, the performance gap between “good” and “bad” managers in each year.  The line is the average level of dispersion during the year.  It’s hardly a perfect fit, but nonetheless it seems clear that managers have more scope to demonstrate their skill when dispersion is high.

In most markets, dispersion in early 2016 was higher than its average 2015 level.  If this trend continues, 2016 could at last see the long-awaited stock pickers’ market, and a widening of the gap between top and bottom performers.  If dispersion reverts to its 2015 levels, however, even good active managers will continue to face a challenging environment.

St. Patrick’s Day didn’t just have a pot of gold at the end of the rainbow, but had basically the whole commodity basket. The S&P GSCI that represents the world’s most significant commodities, ended Mar. 17 with a positive total return year-to-date for the first time in 2016, up 1.9%.

The index reached its highest level since Dec. 10, 2015, and gained 18.8% since its bottom on Jan. 20, 2016. This is the most the index has ever increased in just 40 days after bottoms.

Further, now in March, 23 of 24 commodities are positive. This is the most ever in a month with one exception when all 24 commodities were positive in Dec 2010. It is also the fastest so many monthly returns of commodities changed from negative to positive, making a comeback from Nov. 2015 when just two commodities were positive.

Now, only aluminum is negative in Mar., down 3.1%. However, its roll yield recently turned positive that shows more scarcity (that is very rare for aluminum,) indicating it may turn with the rest of the metals. Especially if the U.S. dollar weakens, the industrial metals tend to benefit most of all commodities. That says a lot about their economic sensitivity given all commodities rise with a weak dollar.

Twice a year, S&P Dow Jones Indices releases the SPIVA U.S. Scorecard.  The scorecard measures the performance of actively managed equity and fixed income funds across various categories.  Since the initiation of the report in 2002, the results have consistently shown that managers across most categories overwhelmingly underperform on a relative basis against their corresponding benchmarks over a medium- to long-term investment horizon.

The Year-End 2015 SPIVA U.S. Scorecard reveals little surprise.  The second half of 2015 was marked by significant market volatility, which was brought forth by plunging commodity prices, a strengthening U.S. dollar, growing global concerns over Chinese economic growth, and the subsequent devaluation of the Chinese renminbi.

Market volatility, in theory, favors active investing, because managers can tactically move out of their positions at their discretion and park themselves in cash.  Passive investing, on the other hand, has to remain fully invested in the market.  Investors in actively managed strategies should therefore realize fewer losses during periods of heightened volatility, all else being equal.

Given this theoretical background, recent volatility in the market has supporters of active investing proclaiming that active management is back in favor.

However, over a decade of experience in publishing the SPIVA Scorecard has painfully taught us that active funds don’t always perform better than their passive counterparts during those precise periods in which active management skills seem to be called for.  Exhibit 1 compares the performance of actively managed equity funds across the nine style boxes during the 2000-2002 bear market, the financial crisis of 2008, and 2015.

As the data clearly show, there is no consistent pattern across most of the categories.  Large-cap value managers appear to be the only exception to the losing trend, outperforming their benchmark in both bear markets.  Again in 2015, mid-cap value is the only winning equity category, with the majority (67.65%) of them outperforming the S&P MidCap 400^® Value.

The world seems to be awash with schisms these days.  There are always great divides in politics, but this year they seem greater than usual.  However, the schisms and splits in the financial world matter more for now: at the Fed, in differing growth rates among the US, Europe and China, and between stocks and oil.

The Fed appears to be divided between the hawks and doves when it comes to raising interest rates. Two speeches last week establish the contrasting positions. Fed Vice Chair Stanley Fischer suggested that inflation may be about to increase while affirming his belief that the Phillips Curve – the inverse relation between unemployment and inflation – is still is worth watching after six years of declining unemployment and flat to falling inflation.  The same day Fed Governor Lael Brainard noted that economic weakness abroad poses a risk to the US, suggesting the Fed might be better off not raising interest rates this year.  This schism should assure no change in the Fed funds target rate on Wednesday when the FOMC meeting issues its statement.

If there is such a thing as a three way schism, it is among growth in the world’s major economies. The US managed 1.9% real GDP growth in 2015, more than double the amount experienced in the Eurozone (0.4%), the UK (0.5%) or Japan (0.8%), but not even close to China’s 6.9% pace.  Even though China’s numbers are expected to slip slightly, this wide spread means that national economic policies may be working against one-another rather than together.  Expect conflicting arguments about managing currency exchange rates or losing jobs overseas.  The US dollar rose about 15% against major world currencies from mid-2014 to mid-2015; putting pressure on US exports while helping other nations’ export activity.

The relative behavior of stocks and the price of oil are another puzzle, although some recent analysis may hold an answer.  The chart shows the prices of the S&P 500 and WTI oil since the beginning of 2014. At first glance the two series move in opposite directions.  Since cheap oil is favorable for most US companies one would expect lower oil prices to be a positive factor for the stock market. However, this pattern reversed for a few weeks last summer and again since the start of 2016.  Two factors that would affect both oil prices and stocks the same way may be behind these reversals. Signs of increasing or decreasing global demand would cause both series to move together, overcoming the impact of lower oil costs. A second factor would be risk-on/risk-off which would push speculators out of both the oil and stock market.  A detailed econometric analysis of these factors is offered by Ben Bernanke.