Accelerate Monthly: Stocks’ Reversion to the Mean

December 14, 2021 — Short selling of stocks was extremely challenging in 2019 and 2020.

Historically, overvalued shares of unprofitable companies dramatically underperformed the market. However, over the previous two years, this market dogma flipped — the more a stock was overvalued, and the more money a company lost, the better its stock performed.

The outperformance of junk stocks has been attributed to a myriad of causes, including central banks’ 0% interest rate policies, quantitative easing, passive fund flows, and extraordinary stock market speculation due to record fiscal stimulus measures (meme stonks anyone?).

Since short selling of securities is generally based on fundamentals such as valuation and profitability (amongst others), the dramatic outperformance of overvalued “junk” stocks has hit short portfolios hard. This junk stock outperformance and related short portfolio pain has caused the level of short selling to shrink to its lowest level in recent history.

It is no wonder that short-selling and hedging have nearly gone the way of the dodo bird. In 2020, Goldman Sachs’ non-profitable technology index, a basket of stocks expected to underperform based on historical data, surged nearly 4-fold. Essentially, if you had short exposure, you got your face ripped off.

Source: FT

Nonetheless, after a brutal couple of years for short selling, in which junk stocks defied the odds and markedly outperformed, we are seeing early evidence of mean reversion. In 2021, overvalued and unprofitable companies have seen their stocks battered. For the few remaining long-short investment strategies, this return to “how it should be” (junk stocks performing poorly) has buoyed hedged investment portfolios.

Anecdotally, Accelerate’s long-short equity ETF, the Accelerate Absolute Return Hedge Fund (TSX: HDGE), has had a banner year in 2021. After two difficult years of losses, HDGE is up 22.5% in 2021. Having a portfolio hedge finally stopped costing performance. The most notable aspect of HDGE’s performance is that it has had a negative correlation with the equity index since inception. It has generally gone up when the market went down — a potential true market hedge when bonds are losing their lustre.

Accelerate manages five alternative ETFs, each with a specific mandate:

  • Accelerate Arbitrage Fund (TSX: ARB): SPAC and merger arbitrage
  • Accelerate Absolute Return Hedge Fund (TSX: HDGE): Long-short equity
  • Accelerate OneChoice Alternative Portfolio ETF (TSX; ONEC): Alternatives portfolio solution
  • Accelerate Enhanced Canadian Benchmark Alternative Fund (TSX: ATSX): Buffered index
  • Accelerate Carbon-Negative Bitcoin ETF (TSX: ABTC): Eco-friendly bitcoin

Please see below for fund performance and manager commentary.

As discussed in the recent AlphaRank Merger Monitor — All Is Quiet On The M&A Front, merger spreads have exhibited a sense of calm and stability. Deals have been closing as expected, with a distinct lack of drama. Nonetheless, the merger market is currently rewarding investors with above-average yields of 8%-9% on average, which compare favourably to junk bond yields.

In our recent post, AlphaRank SPAC Monitor — Calling All Yield Investors!, we discussed how SPAC IPO investors could expect to generate 7% returns with low risk. How? The combination of a $10.20 overfunded trust (2% expected return) and a 1/2 warrant (5% expected return) gives SPAC IPO investors an expected 7% return. This expected return comes with minimal downside risk, as an investor is entitled to NAV at the end of the SPAC’s life

Year-to-date, ARB has successfully navigated the merger and SPAC markets to generate an 8.1% return, nearly 300bps higher than the benchmark S&P Merger Arbitrage Total Return Index’s 5.3% return this year (pre fees).

The market is pricing in 5–6 Bank of Canada rate hikes and 2 Federal Reserve interest rate increases next year. Keeping these potential interest rate hikes in mind, fixed income investors may want to consider alternative fixed income strategies that can do well in a rising rate environment, such as ARB.

After a couple tough years, 2021 had been rewarding for evidence-based long-short investors. The speculative bubble that boosted meme stonks and low-quality, overvalued junk stocks seems to be losing air.

As shown by November’s AlphaRank Factor Performance, HDGE’s short portfolio fell double digits last month, with all long-short factors producing positive alpha.

HDGE surged 8.7% in November, buoyed by its short portfolio. HDGE’s negative correlation to market indices was on display, as the fund’s record monthly gain occurred as the S&P 500 dropped -0.8% and the TSX Composite fell -1.8%.

One criticism regarding ONEC that we occasionally receive is that the fund’s returns are overly reliant on bitcoin.

Alas, this just is not true. While bitcoin fell into a bear market in November, ONEC produced a respectable 1.0% gain.

ONEC’s diversified portfolio of 10 uncorrelated alternative strategies fortifies its returns from being overly influenced by any one asset class. In addition, ONEC’s systematic quarterly rebalancing allows the fund to profit from the underlying volatility of the strategy allocations.

Long-short equity, gold and real estate were the fund’s most significant positive contributors last month, while bitcoin and the infrastructure allocation were its largest detractors.

ATSX dropped -1.3% last month, inline with its benchmark, the TSX 60 Index.

Contrary to US long-short factor portfolios, Canadian long-short factor portfolios did not generate alpha last month. Therefore, ATSX’s overlay portfolio had a nil effect on Fund performance.

Nevertheless, ATSX clients are being “paid to wait” with its current 7.0% distribution yield, making it one of the highest-yielding Canadian ETFs.

Have questions about Accelerate’s investment strategies? Book a call with me.

-Julian

Disclaimer: This distribution does not constitute investment, legal or tax advice. Data provided in this distribution should not be viewed as a recommendation or solicitation of an offer to buy or sell any securities or investment strategies. The information in this distribution is based on current market conditions and may fluctuate and change in the future. No representation or warranty, expressed or implied, is made on behalf of Accelerate Financial Technologies Inc. (“Accelerate”) as to the accuracy or completeness of the information contained herein. Accelerate does not accept any liability for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on all or any part of this research and any liability is expressly disclaimed. Past performance is not indicative of future results. Visit www.AccelerateShares.com for more information.

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Founder and CEO of Accelerate Financial Technologies. Learn more at AccelerateShares.com

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Julian Klymochko

Julian Klymochko

Founder and CEO of Accelerate Financial Technologies. Learn more at AccelerateShares.com

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