Why Active Mid Cap Value Strategies May Outperform
April 2015
2014 was generally a very difficult year for active equity
managers. Across equity styles, most active managers maintained significant and persistent underweights to utilities
and real estate investment trusts (REITs), which were among
the top performing sectors for the year. The underweight was
highest among mid-cap value strategies; in large part a consequence of the 25% average combined weighting of these sectors
within the Russell Midcap® Value Index in 2014. The large
underweight contributed an estimated 175 basis points (bps) of
underperformance for the typical active mid-cap value strategy.1
In this paper, we seek to connect the relative outperformance
of utilities and REITs in 2014 to a contemporaneous decline
in Treasury yields. Our research suggests that, should rates
increase from current levels, utilities and REITs would be
expected to underperform, turning this 2014 headwind into a
tailwind for active equity managers, particularly active mid-cap
value managers.
Background and methodology
Duration, a key component of fixed-income analysis, measures
the relationship between changes in interest rates and changes
in bond prices. Because interest rates are one of several factors
that influence equity prices, the concept of duration can be
applied in equity analysis. But, as we illustrate in the appendix,
the explanatory power of interest rates on equity returns is
often overwhelmed by the impact of other pricing factors, the
most important of which is market risk, or β.
However, we expect that certain equity sectors are more
interest-rate-sensitive than others. If we can remove the impact of market risk from our single factor duration model, we
can more closely gauge the impact of interest rates on sector
returns. We do this by examining sector excess returns over a
proxy for the broad equity market, effectively removing β from
our analysis. The excess return duration model, defined below,
provides a cleaner interest rate beta for sector excess returns.
In regression results, y is the periodic excess return of a sector against the
S&P 500 and x is the periodic change in the 10-year Treasury yield.
Using monthly S&P 500 returns as our proxy for market risk,
GICS sector returns, and 10-year U.S. Treasury yields from
October 1989 to January 2015, we calculated 269 sample
36-month empirical excess return durations for all 10 S&P
500 GICS sectors. From this, we generated the observations
illustrated in Figure 1.
Figure 1: 36-month excess return duration
9/1992 through 1/2015
15
10
S&P materials
S&P utilities
Average across all sectors
5
0
-5
-10
1992
1993
1995
1996
1997
1998
1999
2000
2002
2003
2004
2005
2006
2007
2009
2010
2011
2012
2013
2014
Introduction
Duration in Years
Sources: Bloomberg, FactSet
Two sectors, materials and utilities, were found to have a high
probability (greater than 90%) of exhibiting persistently positive or negative duration.2 In contrast, the average duration
exposure across all sectors was relatively muted. Moreover,
the excess return durations of individual sectors (apart from
materials and utilities) were volatile and often changed signs,
indicating instability in their relationships to interest rates.
The directionally consistent interest-rate sensitivity of
materials and utilities provides evidence that the relationship
is not spurious. This is further supported by intuition. Specifically, the materials sector, often viewed as an inflation hedge,
tends to rise with rates and therefore exhibits negative
duration. The utilities sector, the highest dividend yielding
sector of the market, exhibits bond-like positive durations.
With the 10-year Treasury rate hovering under 2% amid a
strengthening economy, many have anticipated a potential
regime change toward higher interest rates. A move by the
Fed would represent the first such Federal Funds Target Rate
increase in nine years! Prognoses for such a change on fixed-
Figure 2: Russell Index – Sector weights as of 12/31/2014
Cons. discretionary
Consumer staples
Energy
Financials
REITs
Health care
Industrials
Info. technology
Materials
Telecomm. services
Utilities
Russell
1000 Value
6.58
7.38
11.28
29.87
4.74
13.70
10.08
9.55
3.04
2.08
6.44
Russell Russell 1000
Russell
1000
Growth
Midcap Value
12.71
18.69
10.49
8.98
10.54
3.42
7.84
4.49
3.78
17.44
5.36
33.20
3.33
1.96
14.34
13.95
14.19
9.58
11.16
12.22
9.14
19.04
28.28
10.88
3.53
4.01
6.73
2.11
2.14
0.32
3.22
0.09
12.46
Russell
Midcap
17.35
5.75
4.39
20.96
8.52
11.70
12.79
14.52
5.75
0.66
6.13
Russell Midcap
Russell
Growth
2000 Value
23.77
11.69
7.92
2.87
4.96
4.10
9.51
40.96
3.07
15.39
13.68
5.40
16.20
12.94
17.93
9.98
4.83
4.37
0.98
0.76
0.22
6.92
Russell
2000
13.67
3.34
3.47
24.26
9.11
14.77
13.74
17.92
4.50
0.77
3.55
Russell 2000
Growth
15.63
3.80
2.85
7.76
2.91
24.04
14.54
25.76
4.63
0.78
0.22
Source: FactSet
Which styles will be impacted most by a
change in rates?
By their nature, utility companies tend to have moderate
capitalization and demonstrate value characteristics including
low valuation multiples, low growth, and high dividend yields.
This explains their relative importance in the mid-cap value
space, captured in the Russell Midcap® Value Index utilities
sector weighting in Figure 2, above. The materials sector, also
value oriented, likewise has greater relative importance in the
mid-cap value space than it does across other equity styles.
The time series shown in Figure 3 indicates that utilities has
typically been a large and persistent underweight by active
mid-cap value managers. The median underweight of the
mid-cap value peer group averaged nearly 6% over the past
15 years, with no period reflecting an overweight. This bias
is not present in materials, however, where the underweight
averaged only 20 bps, with 42% of observations overweight.
Figure 3: Russell Midcap Value vs. Mid-Cap Value peer
median utilities weight
18
15
12
9
6
3
0
An allocation effect, which captures the value-added of maintaining an active sector weight over a specific measurement
period, can be estimated across mid-cap value peers using the
following definition.
Figure 4 plots the estimated allocation effect from utilities
against the change in 10-year Treasury rate for each of the
past 15 calendar years. The positive slope shows that excess
return from the utilities underweight is proportional to the
change in rates. That is, an underweight to utilities can be
expected to generate a positive allocation effect in periods
of rising rates. With an R-squared of 50%, this relationship
appears to be quite strong.
Figure 4: Estimated allocation effect vs. change in
10-year Treasury (2000-2014)
1.50
Est. utilities allocation effect of median peer
income markets are widely advanced, but we train our focus,
below, on how active equity styles may be impacted.
y = 0.6126x + 0.0555
R² = 0.5038
1.00
0.50
0.00
-2.00
-1.50
-1.00
-0.50
0.00
0.50
1.00
1.50
2.00
-0.50
-1.00
-1.50
-2.00
-2.50
Russell Midcap Value
Morningstar U.S. Mid-Cap Value Peer Median
Source: Morningstar Direct
WELLS CAPITAL MANAGEMENT
12/14
12/13
12/12
12/11
12/10
12/09
12/08
12/07
12/06
12/05
12/04
12/03
12/02
12/01
12/00
12/99
Change in 10-yr rate (BBG)
Sources: Morningstar Direct, Bloomberg, FactSet
Of course, utilities are not the only market segment affected
by changes in interest rates. Another intuitive relationship
exists between interest rates and relative returns in REITs,
2
where high dividend yields can also be expected to lead to
positive, bond-like durations.
The REIT market has changed over the past two decades
and has only recently begun to be recognized as a unique
sector among equities (it currently resides within the financials
sector). GICS, for example, is planning to add an additional
sector for REITs, promoting it from the industry level, in 2016.
Unfortunately, the same depth of historical returns is not
available for the REIT industry, and, as Figure 5 illustrates, the
real estate bubble drove the relative return profile for much
of the industry’s short history.
Similar to utilities, active managers have demonstrated a
consistent bias to underweight bond-like REITs, with the median
mid-cap value manager averaging an underweight of more
than 6% for the past 15 years, again with no period reflecting
an overweight (see Figure 7). This suggests that a transition
to higher interest rates may benefit active managers with
underweights to both utilities and REITs. As referenced in Figure
2, we would expect the largest impact of such an event on the
relative returns of managers within the mid-cap value space.
Figure 7: Russell Midcap Value vs. Mid-Cap Value peer
median REITs weight
16
Figure 5: REIT excess return vs. home prices
(11/2001-5/2009)
10
8
S&P 500 / Real Estate Investment
Trusts - IND vs. S&P 500 Tot
6
4/2009
4/2008
10/2008
10/2007
4/2007
10/2006
4/2006
10/2005
4/2005
4/2004
10/2004
4/2003
10/2003
4/2002
10/2002
10/2001
12/14
12/13
12/12
12/11
12/10
12/09
12/08
12/07
12/06
12/05
12/04
50
12/03
0
12/02
100
12/99
2
12/01
4
150
12/00
200
Morningstar U.S. Mid-Cap
Value Peer Median
12
S&P Case-Shiller Composite-20
250
Russell Midcap Value
14
Source: Morningstar Direct
Conclusion
Normalized index levels, base = 100 on 10/31/2001
Sources: Bloomberg, FactSet
However, the empirical excess return durations since the
collapse of the real estate bubble, shown in Figure 6, reflect
an increasingly strong relationship between rate changes and
excess returns. A February 12, 2015 Bloomberg article quantified
the relationship between S&P 500 Utilities Index and Bloomberg
REIT Index stating that “Correlation between the indicators rose
to 0.960 in [2014] from 0.677 in 2013 and 0.584 in 2012...”3
Figure 6: Empirical excess return duration of S&P 500
REITs: Left axis; Model R-squared: Right axis
(5/2009 – 1/2015)
S&P REITs excess return duration
(36-mo. rolling emperical vs. 10-yr Treasury Yield)
There is strong evidence that in a rising rate environment,
utilities will underperform the broad market. Similarly, REITs
have exhibited a similar relationship since the real estate
crises subsided. Active managers have a consistent bias to
underweight both utilities and REITs, which is particularly
pronounced in the mid-cap value space where those portions
of the market have the largest weight.With the 10-year Treasury
starting 2015 at just over 2%, many market participants are
again forecasting a rise in interest rates. If one believes the
10-year Treasury yield is going to rise, it follows that active
management in the mid-cap value space could experience
tailwinds as the index’s combined 27% weight in utilities and
REITs at year-end 2014 could lag the broader market.
15.00
10.00
40%
5.00
Duration
12/1/2014
10/1/2014
8/1/2014
6/1/2014
4/1/2014
2/1/2014
12/1/2013
10/1/2013
8/1/2013
6/1/2013
4/1/2013
2/1/2013
12/1/2012
8/1/2012
10/1/2012
-15.00
6/1/2012
-10.00
4/1/2012
0.00
-5.00
-10%
-60%
R^2
Chart 1: REITs market, represented by S&P 500 Real Estate Investment
Trusts Industry Index
Sources: Bloomberg, FactSet
WELLS CAPITAL MANAGEMENT
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Appendix
Interest rates changes are one of many factors that can drive
equity returns. The strength and direction of this relationship
varies through time, however, making it difficult to generate
investable themes from interest-rate forecasts alone. Still, it is
useful to build a model to test the importance of the relationship over discreet periods.
To this end, we employed an empirical duration framework
to measure the historical change in an equity index levels as a
function of concurrent changes in interest rates (see sidebar
for more detail).
Where y is the periodic total return of the index and x is the periodic
change in the reference rate.
Sidebar:
In fixed-income analysis, duration is used as a measure of the
expected change in the price of a bond that would result from a
100-basis-point change in yield.
∆Price≈ -1*Duration*∆Yield
We selected the 10-year Treasury yield as the independent
variable because it is a widely accepted benchmark yield that
reflects not only general interest-rate levels, but also market
expectations of inflation and federal fund rate changes. Furthermore, our research revealed the 10-year Treasury yield
generally provided the strongest explanatory power versus
other parts of the Treasury yield curve. Despite the simplicity
of the model (e.g., it ignores changes in the shape of the yield
curve), it demonstrates meaningful explanatory power.
We first test the model against two widely followed bond
indexes; the Barclays U.S. Treasury Index and the Barclays U.S.
Aggregate Bond Index. Figures A1 and A2, below, plot the
36-month rolling empirical duration of the two bond indexes,
as determined by the regression model, and overlays the
model’s R-squared (100% means perfect explanatory power,
0% means no explanatory power).4
Figure A1 and A2: Empirical duration of bond indices:
Left axis; Model R-squared: Right axis
Barclays U.S. Treasury Index
6.00
100%
5.00
80%
4.00
60%
3.00
0%
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
0.00
Duration
R^2
Chart 1: Broad U.S. Treasury market, represented by Barclays U.S. Treasury Index. Sources: Bloomberg, FactSet
Barclays U.S. Aggregate Bond Index
6.00
100%
5.00
80%
4.00
60%
3.00
40%
2.00
Duration
2013
2012
2011
2010
2008
2007
2006
2005
2003
2002
2001
0%
2000
0.00
1998
20%
1997
1.00
1996
Duration is the percentage change in a bond’s price with a
100-basis-point change in yield.”
20%
1995
“The calculation of a bond’s duration based on historical data.
Empirical duration is estimated statistically using historical
market-based bond prices and historical market-based Treasury
yields. When the historical yields change, the historical bond
prices will change accordingly, which forms that basis for empirical duration. Regression analysis is the statistical process used to
estimate empirical duration.
1.00
1993
There are many ways of calculating the duration of a bond. Since
empirical duration uses only historical price and yield information
as inputs, it can be directly applied to non-bond instruments.
Investopedia’s definition of empirical duration:
40%
2.00
1992
For example, the price of a bond with a duration of 7 would be
expected to decline approximately 7% if bond yields broadly
increase by 1% (known as a parallel shift).
R^2
Chart 2: Broad U.S. bond market, represented by Barclays U.S. Aggregate
Bond Index. Sources: Bloomberg, FactSet
WELLS CAPITAL MANAGEMENT
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Having shown that the 10-year Treasury yield is a good
proxy for general interest-rate risk in bond markets, we
can now explore its relationship with equities. Intuitively,
non-interest-rate factors should be more important in
determining equity returns, which would lead to a relatively
low explanatory power of the 10-year Treasury yield. Indeed,
Figure A3 bears out this assumption with R-squared averaging
17% over the analysis period. A more interesting finding is that
the strength and direction of the relationship changes through
time. Specifically, the early portion of the analysis reflects
positive, bond-like duration, while the latter portion reflects
generally negative durations (i.e., as rates rise, equities also
rise and vice versa).5
Figure A3: Empirical duration of S&P 500 Total Return
Index: Left axis; Model R-squared: Right axis
S&P 500 500 Total Return Index
15.00
100%
10.00
50%
5.00
0.00
0%
-5.00
-50%
-10.00
-100%
-15.00
1992
1993
1994
1995
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2010
2011
2012
2013
2014
As expected, we find that variation in the Barclays U.S.Treasury
Index is almost completely explained by variation in the
10-year Treasury yield. The model R-squared averaged 97%
over the sample periods, implying that not much is lost by
looking only at one node of the yield curve. It should also
be expected that the 10-year Treasury yield would have less
explanatory power for the Barclays U.S. Aggregate Index,
where returns are influenced by many other factors, such as
sector and credit spreads. However, the model still exhibits
strong explanatory power, with an average R-squared of 87%.
Duration
R^2
Broad U.S. equity market, represented by S&P 500 Total Return Index
Sources: Bloomberg, FactSet
While changes in rates explain only a portion of the variability
in broad equities, we would expect that certain economic
sectors would be more sensitive to rate changes than others.
In this paper, we adapt the empirical duration framework
defined in the appendix to examine the impact of interest
rates on various economic sectors. Moreover, we look at
which equity styles will tend to be most impacted by potential
changes in interest rates.
1. B ased on the Morningstar U.S. OE mid-cap value fund peer group. Unless otherwise stated, this peer group is used throughout our analysis.
2. T wo sectors, materials and utilities, have had enough persistence in direction and magnitude to be reliable. Utilities have had an average empirical excess return duration
of 4.5, with a standard deviation of 3.2. As such, it would be expected that over 90% of three-year periods will exhibit a positive duration. Materials exhibit a similar persistence, but with a negative average duration of -2.4 and standard deviation of 1.7, leading to a similar probability of exhibiting a negative duration.
3. Bloomberg This Morning, February 12, 2015
4. Unless otherwise noted, all empirical duration analysis was conducted with 269 sample 36-month rolling periods from October 1989 through January 2015. Rolling periods
were selected to reflect how the direction and strength of the relationship changes through time.
5. C
hief Investment Strategist James W. Paulsen, Ph.D. observed and offered an explanation of this change in relationship in his July 9, 2013 Economic & Market Perspective,
available upon request.
WELLS CAPITAL MANAGEMENT
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Joshua T. Demetry, CFA, CIMA®
Director of Portfolio Analytics, Investment Risk Management
Josh Demetry is the director of portfolio analytics at Wells Capital Management.
Prior to joining investment risk management in 2010, Josh managed a team of
associate regional directors and financial consultants at Wells Fargo Advantage
Funds. Josh joined Wells Fargo Advantage Funds in 2005 from Strong Capital
Management, where he began his investment industry career in 2003. In previous
roles, Josh was an associate regional director and an investment specialist. Josh
holds a bachelor’s degree in computer engineering from the University of WisconsinMadison. He is a member of the Investment Management Consultants Association,
the CFA Institute, and the CFA Society of Milwaukee, Inc. Josh has earned the right to
use the CFA designation and is a Certified Investment Management AnalystSM designee.
CFA® and Chartered Financial Analyst ® are trademarks owned by the CFA Institute.
Wells Capital Management (WellsCap) is a registered investment adviser and a wholly owned subsidiary of Wells Fargo Bank, N.A. WellsCap provides
investment management services for a variety of institutions. The views expressed are those of the author at the time of writing and are subject to change.
This material has been distributed for educational purposes only, and should not be considered as investment advice or a recommendation for any particular security, strategy or investment product. The material is based upon information we consider reliable, but its accuracy and completeness cannot be
guaranteed. Past performance is not a guarantee of future returns. As with any investment vehicle, there is a potential for profit as well as the possibility
of loss. For additional information on Wells Capital Management and its advisory services, please view our web site at www.wellscap.com, or refer to
our Form ADV Part II, which is available upon request by calling 415.396.8000. WELLS CAPITAL MANAGEMENT® is a registered service mark of Wells
Capital Management, Inc.
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