Currency & Sector Liquidity Analysis Report: Q4 2018

By Fundata Analytics

When analyzing the Canadian investment space, it is crucial to ask what are fund managers doing with the $1.85 trillion allocated to mutual funds, ETFs and other investment vehicles. Investment funds are often packaged and sold to investors on some criteria, such as targeting U.S. large caps, emerging markets, or specific sectors. But before a Canadian investment manager can invest millions in exchanges around the world, a simple exchange rate transaction must occur as a prerequisite to participate in global capital markets. By analyzing the deployable cash in investment funds, we can assess the street’s market sentiment and get a fix on the liquidity of investment funds on a cash and cash-equivalents basis.

In times of market turbulence, avid portfolio managers are known for their timely increase in cash by selling off a proportionate percentage of securities within the portfolio. On the flip side, they also make calculated bets on earnings and macro-level events by using cash balances in the portfolio to overweight securities and increase overall exposure to the market, ultimately increasing risk. As a general guideline, cash and equivalents can typically range from 1% to 5% of the overall market value of a portfolio in bull to bear markets respectively.

In this report, we’ll focus on the Canadian investment fund industry, and study how portfolio managers are allocating capital in major currencies. The currency analysis excludes all cash equivalents, such as bonds with less than one year to maturity and collateral cash held to fulfill debt covenants. We believe that by excluding these items, we can home in on the deployable cash in investment funds and assess the street’s market sentiment. We than further analyze the liquidity of investment funds on a cash and cash equivalents basis categorized by sector to help us understand which verticals portfolio managers are currently overweighting and underweighting.

Average portfolio weights for world currencies

Chart 1 illustrates the mean cash percentage in Canadian investment funds for nine major currencies in sequential order from January 2018 to December 2018. The U.S. dollar posted a 25.9% decline month-over-month decline for the period ended Dec. 31, 2018, while the Canadian dollar lost 18.0%. Similarly, the Japanese yen (JPY) gained 31.7%, the euro (EUR) lost 7.0%, the British pound (GBP) gained 38.9%, the Swiss franc (CHF) dropped 18.0%, the Australian dollar (AUD) dropped 35.6%, the New Zealand dollar (NZD) dropped 37.4%, and the Chinese yuan (CNY) fell 99.1%.

U.S. and Canadian cash on hand

Chart 2 illustrates the mean cash dollar value in sequential order from January 2018 to December 2018. The U.S. dollar had a net position of $3,146,739,888 for December 2018. The Canadian dollar had a net position of $3,296,695,746 for December 2018.

Capital markets were in a world of pain towards the end of 2018, giving back almost all the gains earned earlier in the year. The market downturn began in early October and continued to the end of December. Taking a look at Chart 1, we see a significant spike in Canadian cash for month end October 2018. In Chart 2 we notice a modest increase in from September to October.

It is important to understand that during a market downturn, the market value of portfolio securities declines, amplifying the weight of cash in the portfolio, since cash holds its face value. We had effectively entered bear market territory in October, satisfying our general guideline of 1% to 5% cash.

Some portfolio managers were seen to react by increasing cash held in funds during October, but in the following months we notice managers “buying the dip” across many sectors. Stock markets have recovered nearly 50% of their losses, and overall pessimism has decreased. Many high-level analysts inflated the panic by stating in their outlooks for 2019 that cash portfolios will outperform the broad market. Because of the V-effect in January, this particular prognostication hasn’t worked out. As the year progresses, we will continue to check the validity of this outlook.

The trend in international markets was bearish. The market weight of the U.S. dollar increased by a material amount in November 2018. The sentiment across eurozone has changed as the probability of a hard Brexit has increased. Most fund managers are currently avoiding equities in the U.K. and are waiting to re-enter the market once investors receive support signs from the government. Growth in China, meanwhile, is still expected to be a staggering 600+ bps, however this was a downgrade from earlier forecasts. EPS growth remains strong in 2019, propelled by the anticipation of a dovish policy turn in Canada and the United States.

Investment Fund Liquidity Ratio

The Investment Fund Liquidity Ratio is calculated as the amount of cash in a fund relative to its total assets. It is important to assess this ratio when analyzing investments and allocating capital. It has the power to give incredible insight into the overall flow of capital into specific verticals and the bullish or bearish sentiment in these investment categories. The accompanying table shows the top and bottom 10 out of 54 applicable sectors based on the mean ratio of over 3,000 investment funds with a mandate to invest in the corresponding sectors.

The red highlights the sectors with the highest ratio, which translates into underweighting their respective indices. This could mean that portfolio managers are expecting negative performance in these categories.

The green highlights the sectors with the lowest ratio, which translates into overweighting their respective indices. This could mean that portfolio managers are expecting positive and alpha generating returns in these categories, in the short term.

Review and outlook

For the month ended September 2018, our Q3 report stated the precious metals category had a top-10 low liquidity ratio, and since then, the price of gold has increased by 10.18% to date. The Natural Resources Equity Category had a top-10 high liquidity ratio in the Q3 report. This category, largely made up of energy and oil-and-gas, led the market decline in last quarter with crude prices retreating to mid-2017 levels.

In forthcoming quarters, we’ll keep a close eye on the commodity space because of its recent increase in standard deviation. We’ll also monitor Canadian Equity for any reversal of losses in the Canadian market, propelled by a more dovish Bank of Canada.

This analysis should help shine some light on how investment professionals are currently handling public equities, and which sectors may require additional due diligence in a portfolio. It is to be taken as just one more tool in your toolbox to help make strategic and informed investment decisions.