Fairtree BCI Income Plus Fund Q4 2024 Commentary

Market dynamics

 The fourth quarter witnessed a turnaround in the relative performance of large-cap to mid-cap indices. The Dow Jones Industrial Average posted a sub-par 0.93% over the period, underperforming the resurgent, tech-heavy NASDAQ, which recovered from its underperformance in the previous quarter. The NASDAQ produced a rather pleasing 6.36% in USD, which ranks as the 31^st best quarter since Q2 2007 or a dataset consisting of 71 quarters. As has become the norm for some time, North American equities outperformed their European and British counterparts, which is not that surprising, given the more socialist-leaning policies that have been adopted in both Europe and the UK. Unfortunately for the UK, which has recently elected a less market-friendly government, the FTSE showed a negative quarter, destroying some 0.18%, and that looks to be about as good as it is going to get over the next few years. One must assume that this is fully discounted, considering that the Chancellor of the Exchequer spent more time changing artworks in No. 11 rather than focussing on realistic and achievable fiscal policy. The solution to labour problems cannot be to nationalise and pay higher salaries, but market fear is that this is merely a taste of what the future has in store for the ever-diminishing British taxpayer. In their defence, they did inherit an already wobbly system, which had slowly degraded over the past decade, but the market will be watching the policy choices of the new decision-makers with keen attention.

Moving to European credit, the iTraxx suite of indices produced more numbers in the black, with the bellwether 5-year Crossover index (75 equally weighted global sub-investment grade names) producing a rather healthy 1.59%, comfortably outperforming cash. Our more favoured two-time levered index produced an even better number at a 2.36% gain, comfortably outperforming the majority of equity indices.  It is most interesting to note that European Credit outperformed European equity indices, with the exception of the German Dax index, which produced 3.02% or the 37th-best rank over the 71 quarterly historical datasets.

Table 1: Major Index Q4 2024 Total Return and historical rankings Q2 2007 – Q4 2024

Source: Bloomberg 31 December 2024

Given the fact that we have 17.75 years of quarterly data, we can do more than just look at the performance numbers as well as the relative rankings. We can also look at relative risk measures, such as standard deviations, Sharpe Ratios (SR) and other measures of risk-adjusted returns. This should be important to investors who do “feel” risk in the diffusion of the performance that they have delivered. For the same absolute return in a portfolio, only a fool would be happy with more risk for that return than less risk. There are many definitions of what risk is, and what is important for one investor is quite different from another, but we feel that the most consistent and comparable is the time-tested standard deviation, which has its roots in its mathematical construct. This makes it totally consistent in its treatment of any distribution of potential outcomes. The simple calculation of mean divided by standard deviation gives a good measure of risk-adjusted return and is one that we tend to like to look at. This is not the SR, as the SR strips out risk-free return as well as the volatility of that risk-free return, but we feel that the basic return per unit risk ratio is a good proxy for the slightly more rigorous SR. Obviously, a higher number is better as the investor receives more return for his accumulated risk. We must be aware, however, that a high number on its own cannot be viewed as the “Holy Grail”, since any low volatility index might deliver high levels of Return Co-efficient but might not deliver that much by way of return. For example, it might be foolish to buy an index that produces a 0.4% annual return with 0.2% annualised volatility – a return coefficient of 2, rather than an index that produces a 12% return with a standard deviation of 8%.

Table 2 shows the annualised returns, the annualised risk as well as the return co-efficients for the major indices that we monitor. These numbers are generated from our historical dataset and, therefore, do include risk periods such as the Global Financial Crisis (GFC), the Greek Government default crisis, the COVID-19 global pandemic, the more recent Ukraine/Russian war as well as the current war in the Middle East, and all the political turmoil in Europe, the UK and the US. Perhaps it is more of the same rather than the exception at the moment, with the world, as usual, teetering on the brink of the potential for some financial fallout, but the traditionalist would suggest that this potential for fallout is the very reason that risk premia exist in the first place. No risk should have risk-free returns; those who choose to take the risk of loss should surely be rewarded for doing so. This line of argument would go a long way in explaining persistence in market returns; the “overvaluation” of US equities has been bandied around for the last two decades, and yet they continue to outperform their European counterparts. Contrary to popular opinion, the outperformance will more than likely continue until participants accept it as the “new normal”. And when that eventually happens, it will probably be followed by a reversal of fortunes.

From a European perspective, Table 2 highlights the outperformance of credit from a risk-adjusted perspective. In fact, the more risk normalised two times levered index solidly outperformed its equity equivalent, offering investors excess return for a given risk target. If an investor is comfortable with equity-type risk, they should be more than happy with the extra return that iTraxx*2 has offered. This index goes a long way to close the relative gap to US equities and provides a rather good fund diversifier to the allocator that has a US strategic overweight.

Table 2: Index Risk-Adjusted Return Co-efficient

Source: Bloomberg 31 December 2024.

As an extension of last quarter’s report, Figure 1 below shows the cumulative return of the various indices in the currency of the particular index domicile. The various performance traces were indexed to 100 at the beginning of the second quarter of 2007 when we had the complete historical data for the iTraxx XOver and Main total returns. 

When looking at Figure 1, it also becomes apparent that there are no returns to risk-free. The worst performing traces over the 17.75 years are the iTraxx Main Index (125 equally weighted global investment grade credit names) and the US Treasuries Total Return Index. Looking at the delivered risk, it becomes apparent that US Treasuries are not the least risk asset class but rather the well-diversified investment grade CDS index – iTraxx Main. Lowest returns but the lowest associated risk over the past 17.75 years.

Figure 1: Major Index Total Return Q2 2007 – Q4 2024

Source: Bloomberg 31 December 2024

 It is difficult to look at the returns and the associated volatility of those returns simultaneously in Figure 1. To disentangle the graphic and the more meaningful comparatives, we produce the delivered risk (as computed by the annualised standard deviation of quarterly returns) as well as the delivered annualised return over 17.75 years. This is shown in Figure 2. If we were to fit a straight line to this dataset, we would observe an upward slope indicating that there is a positive return to risk. Increase that risk, and it should result in a higher delivered return. The corollary of this is also apparent; a reduction in risk will result in a reduced overall delivered return. The textbooks, which have always stated that there needs to be an excess return to risk, are indeed correct.

I have chosen the y-axis scale on purpose to show the effects of the FX translation on the hard currency returns of the non-SA indices. This will become apparent when the comparatives are drawn in a later figure. 

Figure 2: Major Index Risk Return scatterplot Q2 2007 – Q4 2024

Source: Bloomberg 31 December 2024.

The domination in return terms of US equities, which was touched on earlier in this piece, is quite apparent in the figure, but one must be cognisant of the fact that these indices are shown in local currency. This explains the relatively good performance of the South African Top40 Total Return Index, which is based on the rand. To do a proper comparative study, we need to translate all the indices into common currency, and there, the comparative becomes more meaningful.

Figure 3 shows the index returns in ZAR, which again shows the domination of US equities over their European counterparts. The long-term outperformance of US risk assets translated into ZAR validates questions regarding asset allocators’ offshore exposures.

Figure 5: Central Bank Administered Rates

Figure 6: 10 year benchmark yields in US,UK and SA