This article is courtesy Martin Fridson, who writes weekly and monthly high yield bond analysis for LCD News.
Tactical asset allocators may make use of our monthly reporting on industry returns (for momentum-based strategies) and relative value (for value-based strategies). Strategic asset allocators, on the other hand, are more concerned with industries’ long-run, risk-adjusted returns. The table below addresses that need, covering the industries that make a material difference.
We rank the 20 industries based on the table’s shaded column. It contains the Sharpe ratio, calculated by subtracting the mean risk-free return from the industry’s mean return and dividing by its standard deviation. Our proxy for the risk-free asset is the ICE BofA Merrill Lynch US 3-Month Treasury Bill Index, which had a mean return of 0.552%. The observation period consists of all full calendar years for which returns are available on the ICE BAML High Yield Index’s industry subindexes, i.e., 1997–2007.
Under a very strict form of the Efficient Market Hypothesis (EMH) that we might label the Omniscient Market Hypothesis (OMH), all industries would have the same Sharpe ratio. Their returns would differ, to be sure, because industries differ in the inherent volatility of their cash flows, as in the case of cyclicals versus non-cyclicals. Those differences would not necessarily be offset by companies’ financial policies, i.e., use of higher leverage in more stable industries and vice versa. In an OMH world, however, the market would cap prices perfectly in anticipation of both ordinary cyclical variation in cash flows and shocks such as the disruption of Super Retailing (department stores, specialty stores, and discounters) by online merchants. Through this market omniscience, each highly volatile industry’s return would be high enough to produce a Sharpe ratio competitive with every other industry’s.
The table shows how far the reality of the high-yield world is from that idealized vision. Sharpe ratios for 1997–2017 range from as low as 0.08 to as high as 0.37. We conclude that strategic industry allocation decisions made a considerable difference not only in absolute returns, but also in risk-adjusted returns.
As would be expected even under the OMH, historical standard deviations of returns range widely, from 3.594% for Healthcare to 10.978% for Broadcasting. In some cases, investors have been rewarded for accepting high variance by a high average return. For example, Broadcasting topped the list not only in standard deviation, but also in mean return, at 2.854%. Even that return premium over the 20-industry median of 2.505%, however, did not quite suffice to enable Broadcasting to match the group’s median 0.24 Sharpe ratio. Broadcasting came in at 0.21.
Neither was it the case that the lowest return in the group, 1.218% on Telecommunications, was associated with the group’s smallest risk. Rather, Telecommunications’ standard deviation was 7.881%, well above the 6.036% peer group median. Telecommunications’ full-period 1997–2017 performance was dragged down in the Tech Wreck. On an annualized basis, the ICE BofA Merrill Lynch US High Yield Telecommunications Index returned –25.116% during 2000–2002, versus 3.677% for the ICE BofA Merrill Lynch US High Yield Excluding Telecommunications Index. Clearly, the market extracted far too small a penalty rate on Telecommunications issues heading into the 2000 blowup.
Marty Fridson, Chief Investment Officer of Lehmann Livian Fridson Advisors LLC, is a contributing analyst to S&P Global Market Intelligence. His weekly leveraged finance commentary appears exclusively on LCD, an offering of S&P Global Market Intelligence. Marty can be reached at [email protected]
Research assistance by Kai Zhao and Yaxian Li.
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