Should “rand coverage” be viewed as an investment style factor?

27four Investment Managers’ quantitative research team began tracking an additional factor on the JSE. As part of its Q3 style analysis, 27four included “rand hedging” and its opposite “rand tracker” as risk premiums in the local market.

“If you look at typical asset manager vernacular, everyone uses the term ‘rand hedge’ quite openly,” said Daniel Page (photo), quants manager at 27four. “We looked at what happens if you convert that into an investing style. If you sort stocks based on their sensitivity to changes in the rand, is there some kind of premium to extract? ”

The stocks that 27four considers “hedging the rand” are the 30 stocks of the top 100 companies by market cap that posted the highest currency beta in the previous 252 trading days. Rand tracker stocks are those that posted the lowest currency beta during the same period.

Tracking this, Page added, is particularly relevant in a market like the JSE, where a significant majority of the income generated by locally-capitalized stocks is in foreign currencies.

“If you think about the big miners and Naspers in particular, they have a huge amount of their income, expenses, even their balance sheets driven by currency fluctuations,” Page said. “So if the rand depreciates, the miners are generally doing well and Naspers is doing well.”

“So just like with other styles – where it is understood that certain factors in a stock dictate what its process of generating returns is – we said why don’t we look at stocks on the JSE that have different levels. sensitivity to changes in the rand.

Style dynamics

Page said that certain dynamics arising from currency risk are well recognized and recognized. It is therefore logical to follow these dynamics more closely.

“We’ve included it now because of the recent momentum on the JSE. As of November of last year, the value game has mainly focused on mid-cap rand trackers – stocks strongly tied to the South African economy. These are the high value stocks, and they are also the stocks usually hit hard when the rand depreciates against the dollar.

“What we’ve seen over the last 10 or 11 months is that some of them have done incredibly well. And with that, there has been a re-emergence of the small cap premium on the JSE. ”

These interactions between risk premia are of particular interest to Page.

“No sharing is just one thing or another,” he said. “That’s why we’re looking at the correlations.

“You can sort stocks by a particular style, but regardless of the type, there are always stocks that also have weighting against other styles. Momentum, for example, is all that has been done well lately. This is generally strongly correlated with growth. And this has generally been strongly correlated with rand coverage. ”

Likewise, what 274 describes as “losing” stocks – those with the weakest price dynamics – tend to correlate strongly with value.

“These are stocks that have been hit by the market, and their prices are low compared to history,” Page said. “Before the Covid-19 withdrawals, you had a whole bunch of rand tracking stocks – stocks related to the South African economy – that people didn’t want to own. And so this correlation was strong.

Appreciate the correlations

However, these correlations change over time, and the way they do so reveals some interesting dynamics in the market.

“For example, quality should – by its pure definition based on a measure of profitability like return on assets and return on equity – be strongly correlated with stocks with low levels of earnings volatility. This should translate into low volatility in stock prices.

“But we don’t always find that. What we saw during the global financial crisis of 2008 and 2009 is that low volatility performed incredibly well. But in Covid, the quality has worked incredibly well. There was a flight to quality as people looked for companies that could weather the storm, ”Page said.

According to 27four’s analysis, factor-weighted quality on the JSE has returned 10.19% per year for the past three years. Low factor-weighted volatility returned -6.13% over the same period.

In recent times, however, there have been correlations between small cap stocks, unwanted (low quality) stocks, and tracking rand stocks.

If one accepts that long-term returns should always be the highest of the assets requiring the highest risk premium, then this makes sense.

“An article we wrote in 2017 stated that the rand tracker, in the long run, actually outperforms the rand coverage,” Page said. “We wrote this article with data up to 2016, and obviously since then rand hedges have dominated so this argument has fallen a bit flat.

“But if you look at the long term, the risk-return argument is that a trailing rand action is strongly tied to our economy. This means you have both localized idiosyncratic risk and offshore event risk. which may have an impact on the South African economy.

“Typically, companies that are not only tied to the local economy, but have a diversified portfolio or naturally earn overseas with an offshore-based balance sheet, are less susceptible to events in the industry. South African economy. They are less risky. So, you wouldn’t expect such a premium associated with these stocks over time. ”

Patrick Cairns is Editor-in-Chief for South Africa at Citywire, which provides insight and information to professional investors around the world.

This article first appeared on Citywire South Africa here, and republished with permission.

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