Your questions, our answers
In our latest issue of Clear and Simple, our Portfolio Managers discuss whether cryptocurrencies play a role in the portfolios of the Ethna Funds, to what extent equity lending and short selling are used in the Ethna-DYNAMISCH, and whether a shorter or even negative duration would be an option for the bond portfolios of the Ethna Funds. They also explain what a barbell strategy is and discuss the current potential of the European banking sector. Finally, they look at the future prospects for equities.
Elon Musk, the CEO of TESLA, recently announced that they will accept payment in Bitcoins increasing the value of the cryptocurrency even further. Would you ever consider including a small allocation in a cryptocurrency as a diversifier in either the Ethna-AKTIV or the Ethna-DYNAMISCH? Or do you consider this asset class too speculative for your strategies?
Cryptocurrencies represent one of the most exciting financial innovations of the past decade. Starting from the basic idea of a payment system that is supposed to function without financial institutions, thousands of cryptocurrencies have now been developed on the basis of the underlying blockchain technology. One of the reasons for the large number of cryptocurrencies is that the "perfect" cryptocurrency does not yet seem to exist. As a result, new concepts are constantly entering the market to eliminate the weaknesses of the existing cryptocurrencies. At the same time, all of the major central banks are also developing concepts for future digital currencies. In light of this, it seems only a matter of time before cryptocurrencies find their place in multi-asset funds.
However, it will still take some time before that happens. But in order to benefit from this development in the interim, the Ethna-AKTIV has taken a small position (approximately 1%) in a Blockchain ETF. In contrast to a direct or indirect investment in a cryptocurrency, this is a pool of companies that deal with blockchain technology.
Following the recent events surrounding the shares of Gamestop and AMC, have you set up new portfolio parameters to ensure that the stocks included in the Ethna-DYNAMISCH portfolio are not victims of a stock war?
No. This is not necessary in our case. To better understand this, it is worth taking a closer look at the potential risks.
On the one hand, risks can arise from short positions if the price of the share does not fall, as assumed by the initiator of the short position, but instead rises. This was the case with the shares mentioned. Hedge funds borrow shares from other investors for such an action in order to then sell them "short". Ideally, they can then buy these shares back more cheaply and book the difference - minus a lending fee for the actual owner of the shares - as profit. The dangerous thing about these types of uncovered positions is that although the share sold can fall to a maximum of zero, it can theoretically rise to any high price. In short, the maximum profit is capped, but the maximum loss is not. This is one of the reasons why only very specific (hedge) funds are allowed to sell short. And only under strict conditions. For example, a sufficient safety margin must be deposited at all times to ensure that the short seller can settle any losses from the transaction. If there is any doubt, the short-sold share must be redeemed on the market and returned to the lender. This happens comparatively often in practice and is called a short squeeze. Often an unexpectedly positive company announcement is the reason for rising prices. The necessary cover by the short sellers then further drives the price and can really catapult it upwards. In the most recent examples, however, it was not company announcements that triggered the initial price rises, but purchases by countless private investors coordinated over the internet specifically for this purpose.
As the risks associated with short selling are considerable, all of the Ethna Funds are prohibited from short selling. In addition, when we launched the Ethna Funds, we decided not to lend the shares held in our portfolios. This can also give rise to risks if the counterparty to this type of lending transaction becomes insolvent in the interim.
In addition to these direct risks, there are also indirect risks that can arise in the event of stronger market distortions. Whenever market participants run into liquidity bottlenecks, they are forced to obtain liquidity. This usually involves selling the most liquid positions, which include large-cap stocks. So-called "crowded trades", which refers to the equity market favourites of a particularly large group of investors, are particularly susceptible to this type of liquidity selling. As investor sentiment has always played an important role for us in the management of the Ethna-DYNAMISCH, such considerations are definitely included in the decision-making process for single stocks and for the portfolio composition. We have been doing this long before the GameStop incident.
In a continuously rising interest rate environment, do you think about shortening duration even further? Would you consider switching to negative duration?
First of all, we need to be clear that although the term rising interest rates might be used a lot right now, it is only at the long end of the US Treasury curve that we are actually seeing any rate increases. Even the 2-year Treasury yields reached a new low of below 0.1% in February of this year while the 5-year Treasury yields reached a low of 0.35% one month prior, in January. We should also note that these lows are not restricted to the US, with the Italian government bond curve recently reaching lows for all maturities. But let’s come back to the long-end of the US Treasury yield curve for a moment. Yields on 10-year Treasuries hit a low of nearly 0.5% in August 2020 before climbing to almost 1% just after the US presidential election in November, then increasing again to 1.15% when the Democrats also gained a majority in the US senate following the Georgia run-off elections.
So, what does this mean for the allocation of the Ethna Funds? In light of the points outlined above, we are convinced that reducing duration or even moving into negative duration is only an option for the US bond portion of our portfolios. For example, the Ethna-AKTIV has already reduced duration for its USD bond allocation, which accounts for 25% of the entire fund, to 1.4.
However, there are two additional points that we need to take into account before going short on USD duration. Firstly, duration always serves as a hedge against a weaker equity market. Therefore, as our funds currently hold their maximum equity-quotas, our risk management should also be a focus. Were equity markets to fall sharply, we should see a corresponding significant drop in long-term Treasury yields. In this type of environment, if we are short in terms of duration, our capacity to withstand this scenario and mitigate any losses from the equities would be limited, so that the losses might very quickly exceed tolerable levels. As we want to minimise these types of risks in our funds, it restricts our ability to go short duration.
A second aspect we need to consider is that we need a period of steadily rising yields to benefit from negative duration, as the carry on the short Treasury trade is negative. If we look at the month between 11 January and 11 February 2021, the 10-year yield is roughly unchanged at 1.15%, but the future price has increased by roughly 0.3%.
So, the conclusion is that although it is possible to enter negative USD duration, we have to carefully consider this move within the portfolio context and our risk appetite, as well as taking into account the negative carry of going short duration.
Could you please explain why a barbell strategy is a prudent strategy in the current environment?
In a multi-asset context, a barbell strategy looks for an optimal balance between opportunity and risk, in which the portfolio is more heavily invested at both ends of the risk spectrum. Any investment in between is avoided. For the Ethna-AKTIV, in particular, this means the maximum historical weighting in equities on the one hand and a very conservative portfolio of corporate and government bonds aimed at capital preservation on the other hand. In our view, this avoids duration and spread risks that are currently not adequately compensated, while still providing an attractive average return.
The catalyst for this type of portfolio construction is the historically low risk premium for corporate bonds. This was caused by the very accommodative monetary policy of the major central banks, which has continued since the financial crisis in 2008 and was eased again over the course of the last year.
Why are you currently investing in the European banking sector?
While there are a number of factors in favour of investing in European banks, there are still sufficient counter-arguments from a strategic point of view. This is why it is important to stress that this is currently not a strategic position, but a tactical one. This type of positioning reflects the opportunistic and flexible nature of the fund.
But what are the reasons to buy? In addition to more technical factors, such as a broad underinvestment and the fact that the recent consolidation lows have been maintained, it is above all fundamental reasons that have persuaded us to buy. Even if one has to take a critical stance on the business model of many banks over the long term, they should be able to profit doubly from the scenario we have anticipated. They are winners of both the economic reopening and the reflation trade. The improving contribution from maturity transformation due to slightly rising interest rates should of course not be overvalued here, but nevertheless provides some price optimism for a sector that has only participated below average in the price recovery of the last 12 months. In addition, the election of Mario Draghi and the hoped-for political stabilisation in Italy will eliminate a negative scenario for banks, at least in the short term.
Valuations are currently stretched on the equity side; do you see further potential there?
As measured by the most common valuation ratios, such as price-to-earnings ratio (P/E), price-to-book ratio (P/B ratio) or price-to-sales ratio (P/S ratio), most equity markets are indeed at the upper end of the valuation scale observed in the past. And the now very well-known Shiller P/E ratio, named after the US economist Robert Shiller, which smooths earnings over a 10-year economic cycle, is also at correspondingly high levels compared with its own history. However, no informed statement can be made on this basis about the further return potential of the equity markets for the coming months and years. Robert Shiller was only able to substantiate the connection regarding the longer-term returns of the following 10 years in his studies. So, in the past, above-average equity market returns could be observed in the wake of a low Shiller P/E ratio, while increased values of the Shiller P/E ratio led to below-average equity market returns. All these classic valuation ratios have one thing in common: they provide an absolute valuation of the equity markets.
However, if we look at the relative valuation of the equity markets, a much more constructive picture emerges compared to other investment alternatives. Interest rates, for example, function as the general price of money and, therefore, also as the ultimate valuation yardstick. And interest rates - long-term over 10 or 30 years as well as short-term over 3 months or 1 year - are at the lower end of the range observed in history throughout the Western world. The implications are significant. The earnings yield, calculated as the reciprocal value of the P/E ratio - i.e. earnings divided by price, instead of price divided by earnings - illustrates the connection: a P/E ratio of 20 is equivalent to an earnings yield of 5% and currently corresponds to the figures of a global equity portfolio based on the earnings expected for the next 12 months. Intuitively, it becomes clear that an equity earnings yield of 5% is significantly more attractive in an interest rate environment with bond yields of 1% than in an environment with bond yields of 8%. If the bond yields mentioned refer to secure government bonds, the difference is also referred to as the equity risk premium. It is intended to express the extent to which higher risks on the equity markets are rewarded compared to secure government bonds. In the first case, the equity risk premium is +4 % (5 % - 1 %), in the second case -3 % (5 % - 8 %). Accordingly, absolute equity valuations are relativized in a relative - and relevant (!) - context.
As a result, we also see further potential for the equity markets on the valuation side, which is currently expressed in structurally high equity ratios in all of the Ethna Funds.
Please contact us at any time if you have questions or suggestions.
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