Monday, December 16, 2013

Stress Test: Performance of Lipper Groups Under Two Key Scenarios: Fed QE Taper Or Deflation

Remember, your milage may vary.
From Alpha Now:
The Fed has become the prime market mover. Going forward, decisions made by the new chair will likely be the most important factor driving world markets. With historic highs observed in a variety of inflated financial markets, what are the plausible scenarios that lie ahead? What will be the performance of various mutual funds and ETFs under these scenarios?

We have already written about the longer term possibility of inflationary pressures and performance of funds here. However, inflation is not a likely scenario in the near term and we will focus on more immediate alternatives.

QE Taper in 2014
The first one will be a significant QE taper by the Fed sometime in the 2014. The importance of that move is rather psychological, as there are many other ways that the Fed will continue to support the markets after the taper, should it occur. However, two previous attempts resulted in major drawdowns; last one in spring of 2013 even spread across asset classes (equities falling while interest rates were rising). So, it is unlikely that the hypothetical 2014 taper will be received calmly, especially with valuations where they are now.

Deflation Scenario
The taper is possible only if key economic measures in the U.S. continue improving but it will be nearly impossible if there is a crisis elsewhere in the financial system; for example, if there is a hard landing across the emerging markets economies. Such a crisis would unleash another round of deflation (much like the euro sovereign debt crisis did) and taper would be out of the question.
How might funds perform?

We will use the stress testing engine powered by Lipper data and a multi-factor model by RiXtrema to analyze the performance of various peer groups in the two scenarios: taper and deflation. To learn more about the quantitative mechanics behind stress testing, see this presentation. Table 1 describes the specifications for the two stress tests that are designed to produce the effects of two scenarios. For more on the reasoning behind the Fed QE taper shock specs, watch this interview with legendary risk manager Barry Schachter.
The shocks in table 1 are entered into a multifactor risk model and a stress testing engine. The engine then specifies the conditional moves for other factors in the model, for example, what happens to international equities or commodities in case the shocks to rates, spreads or U.S. equities in the table are observed. We can then use mutual fund and ETF exposures to the factors to calculate the resulting impact on any fund.

Average Lipper Group Returns
First, we examine the top and bottom ten performing Lipper groups (only groups with more than 30 members are included) under these two plausible macroeconomic scenarios. Table 2 shows average returns for top and bottom groups in the “Fed Tapers QE” scenario and Table 3 shows the same for the deflation scenario. We can see that the top performer in both scenarios is, unsurprisingly, the Dedicated Short Bias Funds group (14.93% and 13.1% respectively). Among the poorest performing groups in both events are Equity Leverage Funds (-26.54% and -19.9%). However, similarities largely end there....MUCH MORE