Japan in Only the Fifth Inning and Alternatives Focused Discussion

Last week on our podcast we spoke with Michael Churchill of Churchill Research, an independent research firm that provides commentary across the global markets, and Sal Bruno, Chief Investment Officer of IndexIQ, a division of MainStay Investments.

The discussion centered around investment themes that Churchill is focused on today and some of the developments in the exchange-traded fund (ETF) industry that IndexIQ is attacking—many of which are centered in the alternative, fixed income and international equity arenas, areas both Michael Churchill and I share Bruno passion for innovating in to provide differentiated tools to traditional fund exposures.

With Bruno, we touched on the active versus passive conversation; his background as an active portfolio manager at Deutsche Asset Management provides good insight into the role for ETFs and how he sees ETFs serving many of the strategies historically applied by active managers.

Highlights of the conversations with each guest included:

With Michael Churchill:

•    How a lot of Churchill’s research centers around the price of gold as indicative of the current regime.

•    Churchill is looking at several of the non-commodity growth stories in emerging markets—one of which is Sri Lanka. There was an interesting conversation about Sri Lanka through the financial crisis—which was less impacted by reduced global flows, due to its few investors, and thus was relatively unscathed at the time. He first went there in 2009, during a period of war, and saw how much modern development was going there. He thinks it is one of the nicest places in South Asia—better than India and Pakistan as a tourist destination for Europeans; it is just too far for most Americans.

•    Japanese small caps: Churchill has been focused on Japan for the last four to five years and thinks we are currently only in the fifth inning of the recent upward moves in the Japanese markets. With the election of Abe and Kuroda, there was political unanimity in ending deflation. For 30 years, nobody cared about Japanese investments, evidenced by the wide swaths of stocks selling at very depressed multiples. Churchill points to Japan’s very low unemployment rates, pickup in real estate prices and margin improvements that are starting to take place. He is very focused outside large-cap Nikkei 225-oriented stocks and much more small caps. He sees many examples of companies that had operating margins between 0% and 2% in the 2008–10 time frame and today are closer to between 4% and 6%. These margin improvements, combined with low valuations, are leading to very strong returns.

•    One of Churchill’s focus points were his travels to various countries, the notes of which are being turned into an upcoming book called Stock Analyst Trip Notes 2008–17: Crash and Recovery from Buenos Aires to Hanoi. Churchill is reflective of his 2008 portfolios that were smashed during that period and ponders the lessons learned from that experience. His honesty was refreshing.

With Sal Bruno:

•    Why he left the traditional active mutual fund world for the ETF side: the structural differences with the creation/redemption process to impact tax efficiency, the administrative costs that lead to lower expense ratios, transparency and liquidity.  

•    Focus on alternatives: Bruno is focused on hedge fund-oriented strategies such as hedge fund replication, merger arbitrage and long/short equities. In terms of where the potential future market is, Bruno believes we still have a lot of runway ahead of us for liquid alternative strategies. We touched on how hedge fund replication strategies can add value as a dynamic asset allocation strategy that take the best of hedge fund manager positioning, and more specifically, an idea surrounding merger arbitrage indexes.

o    Bruno is seeing a large pickup in merger and acquisition activity—which is feeding interest in merger arbitrage strategies. He sees the beta of these indexes as being in the range of 0.15 over the long run, and the long-run returns to these strategies being in the mid-single digits, around 4%–6%. This has been the case for the last five years.

•    Fixed Income smart beta development: While factor investing started with equities, Bruno and I agree that there will be further work around factor investing in fixed income. His team has looked at applying the momentum factor to fixed income subsector asset rotation and low volatility (low vol) as a factor within the high-yield bond market. We are also in agreement that investors need to look beyond the traditional market cap-weighted benchmarks and start looking to factors in the fixed income market—whether enhancing yield like some of WisdomTree’s Index strategies, focusing on quality within the high-yield market, or the low vol factor. We both agree people should consider moving beyond fixed income beta.

•    Finally, we also briefly touched on an international equity discussion and different approaches for managing currency risk.

It was a great conversation with both Bruno and Churchill.