RGA Investment Advisors commentary for the third quarter ended September 330, 2016; titled, “On the Matter of Correlations.”
The third quarter was a strong one, with the S&P rising 3.26% and the Russell 2000 tacking on 8.03%. After several consecutive years of summertime volatility, the summer of 2016 saw an historic volatility compression. This certainly was not a summer to “Sell in May and Go Away” (while we are here invoking that line, it’s important to caveat that even were it a successful strategy—and it’s not—it runs entirely contra to our philosophy of finding and investing in high quality businesses).
[drizzle]All sectors were not equally strong, however, with notable weakness in the yield-sensitive areas. In our May Commentary we told investors to have their “staple remover ready” and the point applies similarly to Utilities and REITs. These three sectors (just last month the REITs officially became a sector of their own) share one very important trait in common: they have each become proxies or replacements for investors in the quest for yield amidst seven years of Zero Interest Rate Policy (ZIRP).
From our vantage point, some of these trends towards dividend investing involve conflation of several themes that have become popular in recent years:
- Quality investing—what has become synonymous with the search for companies with consistently high ROICs and mid-single digits growth
- Dividend—the increasing popularity for anything and everything with yield
- Low beta/volatility—people have gotten frustrated with the whipsaw moves in markets and have been isolating companies that are more immune than others.
When someone not steeped in the financial lexicon is overwhelmed with certain themes, it becomes all too easy for confusion to take over. It also becomes too easy to take what are good ideas with a solid foundation to an extreme far beyond reason.
The strength in these sectors over the past few years has been driven by allocators targeting certain levels of yield for portfolios and not by investors analyzing businesses and determining a fair worth. This is an important distinction. Additional drivers have been a preference on the part of investors for lower volatility and a movement towards passive (from active) types of management. In the modern incarnation of passive management, portfolio managers seek to capture factor exposures in desired proportions generally via ETFs.
During the last quarter, there was an important change in the yield sensitive names that we think has gone largely unnoticed but will be meaningful going forward. Since equities are long duration assets, and the short-term rates are set directly by the Federal Reserve Bank, we decided to use TLT as a proxy for long-term rates. We first looked at the average daily returns and standard deviations of the S&P, TLT and the yield sensitive sectors over the past three, six and twelve months:
There are two important takeaways from this chart:
- All but one sector—XLU (Utilities)—has a lower volatility (standard deviation) over the past three months than over the past year. This is a distinct change in character for the Utilities, a sector that generally is not very volatile.
- The average daily return over the last three months in every yield sensitive area (Treasuries itself, and Utilities, Staples and REITs) has turned negative, while the S&P remains positive, on average, every day.
This was the first step in calculating the betas of yield sensitive areas compared to each the S&P and Treasuries. Here are those betas:
Note that the betas of XLU (Utilities), XLP (Staples) and IYR (REITs) are greater with respect to TLT than they are with respect to the S&P. Further, in our timeframe comparison, these betas have actually lessened as time has gone on—the betas of these sectors verse the S&P are less over the past three months than over the past twelve months. In fact, the Utilities sector is slightly negative against the S&P over the past three months meaning that for each unit the S&P went up, the Utilities actually went down.
There is an extremely important takeaway here worth emphasizing:
If you are buying these sectors today, you are making an explicit wager on the direction of long-term interest rates.
While some may think they are engaging in some kind of investment, diversification or capture of yield, in reality they are wagering on the direction of interest rates. Yes, to an extent there will be some yield capture along the way, but one problem with low rates is how the sensitive the principal (your invested dollars) is to the change in yields. If it is yield you seek, we are afraid to tell you that this market does not offer much of it. If instead you are looking to make an explicit wager on interest rates, there are far better ways to do it than through these vehicles. Needless to say, we feel many investors are in these places right now for all of the wrong reasons.
You may have noticed that all this while, we have spoken about the “yield sensitive areas” without touching on XLF (the financials)—the other sector in our grids above. We are saving this for our conversation below.
RGA Investment Advisors – Portfolio Update:
After an active first half of the year for portfolio activity, the second half has had a slow start. We made one notable portfolio change—we purchased shares in The Charles Schwab Corporation (NYSE: SCHW). We love when a confluence of themes we believe in come together in one company, with a reasonable valuation. Our business, our investment in Envestnet (NYSE: ENV), and now our investment in Schwab (NYSE: SCHW) all are at least partly premised on the big transition from a commission-based to fiduciary, fee-based wealth and asset management industry. Registered Investment Advisors continue to grow at the expense of the brokerage wirehouses, reporting double-digit annualized growth for over a decade.
At first glance, the online and discount brokers are typically associated with cheap commissions for retail clients. Yet at Schwab, this is a small and diminishing part of the story. As recently as 2011, trading revenues accounted for more than 20% of the company’s total top line. Today, trading accounts for about 14% of revenues. Net interest revenues have been the primary beneficiary in terms of total revenue share—rising from 37% to 40% of net revenues. Notably, net interest revenues have grown in share despite the persistence of the Fed’s zero interest rate policy and the corresponding waiver of money market fund management fees.
Despite the money market fee waiver headwind, Schwab has exhibited consistent operating leverage throughout the post-crisis period. Each year has seen an average of a 1% operating margin increase, with 2016 seeing an accelerating on the heels the December 2015 rate hike—the first since getting down to 0% in late 2008.
This growth is impressive and stems from the company’s consistent ability to provide value-added services to retail and institutional clients, fostering consistent double-digit asset growth and mid-single digit account growth. A great example of this is the traction Schwab continues to make in its robo-advisor offering (what Schwab calls “Intelligent Portfolios). Assets now exceed $10b, with many of