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Focus – finding alpha in equities

Hunting for alpha in Asian equities

10 October 2022

Julien Lafargue, CFA, London UK, Chief Market Strategist; Nikola Vasiljevic, Zurich, Switzerland, Head of Quantitative Strategy

Key points

• With stock pickers finding it much tougher to generate alpha in developed markets, can Asian markets ride to the rescue?
• We certainly see investor potential there, as the region continues to offer plenty of opportunities for those with the know-how and risk budget to capitalise on them
• Historically, skilled stock pickers focusing on Asia have been better off than alpha seekers in the US market about 85% percent of the time since 2005
• To protect and grow wealth in highly volatile times, having a diversified portfolio is key. In doing so, one alternative asset stands out: market neutral equities

Equity markets might be tough hunting grounds for investors this year. Views are also split on whether the worst is yet to come or is behind us. When equities appear directionless, because of elevated uncertainty or a lack of conviction, opportunities can still be found, and Asia offers plenty of them.

Financial market sell-offs are frequently driven by macro news and sentiment. Stock prices often plummet in a crisis, with volatility and correlations spiking and being especially elevated for some time. Charging inflation and interest rates have exacerbated this problem recently by ushering in a regime of positive correlation between equities and government bonds.

It’s all about alpha

For months now, we’ve advocated the importance of being (and staying) diversified. In particular, we’ve been vocal about the need, when appropriate, to consider investing in alternative assets to target better risk-adjusted returns. With that simple goal in mind, one strategy might be worth considering: market (or beta) neutral equities.

Behind the fancy name, these strategies eliminate the need to get the market’s overall direction right (the beta) and instead focus on generating value by going “long” an asset and shorting another one with similar characteristics. This idiosyncratic performance is commonly referred to as alpha.

Dispersion, dispersion, dispersion

In order to generate attractive alpha, fund managers need two things, a rigorous process and talent. But these aren’t of much help if alpha opportunities are few and far between. This is why dispersion of returns between markets or securities and low intra-correlations are two prerequisites.

Unfortunately, the influence of central banks on markets in recent years has suppressed a lot of the alpha opportunities that once existed. Indeed, an increasing number of investors simply follow the market’s momentum in setting strategy, paying little attention to fundamentals.

This tide, that lifts all boats, makes alpha generation harder, especially in the western world. In fact, the S&P Indices versus Active (SPIVA) scorecard, which tracks the performance of actively managed funds against their respective category benchmarks, recently showed 79% of domestic equity funds underperformed the S&P in 20211.

Asia is an ideal hunting ground

However, alpha generation has been easier to come by in Asia. There are a few fundamental reasons for this.

First, Asian equity markets, unlike their US peers, include companies from very different countries that each face their own macro trends (some being emerging markets). Second, Asian companies not only operate in many currencies, but their shares are listed in different currencies too. This makes exchange rates a key driver of alpha. Finally, stock markets in the continent offer exposure to a very specific blend of sectors and industries that allows for additional dispersion.

Running the numbers

To help illustrate the potential alpha available in Asia, we have looked at the cross-sectional performance dispersion of US and Asian-Pacific (including Japan) large-cap stock markets since January 2005, both areas being measured in US dollars. Our performance dispersion measure is based on the interquartile range, defined as the cross-sectional difference in stock returns between the 75th and 25th percentile.

Our analysis shows that the average performance dispersion exhibits mean-reverting behaviour over longer periods of time. However, it can also be seen over investment horizons of three to six months.

Asia-Pacific offers more stock picking opportunities, with a performance dispersion that has been 2.6% higher on average. Since 2005 this spread even reached 10% on occasions, typically during downturns in US equity markets (see chart).

Alpha hunters might be even more attracted to Asia-Pacific dispersion trades if we measure the performance dispersion as the difference between the best and the worst performing stocks (as opposed the interquartile range which is a more statistically robust). In that case, the spread versus the US stock market was 20% on average, and has topped a mindboggling 200% two times over the last 17 years (2011 and 2021).

The above numbers clearly back long-short equity strategies in Asia-Pacific. Historically, skilled stock pickers focusing on this part of the world have been better off than alpha seekers in the US market about 85% percent of the time since 2005. Needless-to-say, past performance does not guarantee future performance.

 

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Alpha hunters might be even more attracted to Asia-Pacific dispersion trades if we measure the performance dispersion as the difference between the best and the worst performing stocks (as opposed the interquartile range which is a more statistically robust). In that case, the spread versus the US stock market was 20% on average, and has topped a mindboggling 200% two times over the last 17 years (2011 and 2021).

The above numbers clearly back long-short equity strategies in Asia-Pacific. Historically, skilled stock pickers focusing on this part of the world have been better off than alpha seekers in the US market about 85% percent of the time since 2005. Needless-to-say, past performance does not guarantee future performance.

Eleven sectoral shades of the same colour

Significantly lower correlations between Asia-Pacific stocks can explain their superior dispersion properties against the US stocks over the last five years, according to our quantitative analysis (see chart). The same outcome is obtained when stocks are grouped by sectors.

Both regional markets follow a similar pattern in terms of relative correlations. However, overall Asia-Pacific is a clear winner as average correlations in each sector are lower than their US counterparts. As such, they are not driven by specific segments of the two equity markets. The discrepancy is significant in all sectors, being most pronounced in energy and utilities, followed by industrials, real estate, and financials.

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A is for Asia and for Alpha

At a time of high uncertainty in equity markets, removing market risk is an attractive proposition. But without beta, investors have to rely on alpha to generate returns. Fund managers and stock pickers have found that excess returns are proving to be increasingly scarce, at least in developed markets.

However, Asia continues to offer plenty of opportunities for those with the know-how and risk budget to capitalise on them.

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Market Perspectives October 2022

As bond yields zoom up, central banks get more serious on rate hikes, and recession risks become real, the mood in financial markets is glum. This month’s report attempts to put these short-term moves into context, providing insight and reasons why the longer-term picture looks more encouraging.

In addition to our usual asset class and financial market analysis, you’ll find our sustainability section, where we take a look at how beefed-up regulations may reduce “greenwashing” risk, and help to add value to a portfolio.

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