The quantitative research team at 27four Investment Managers has started to track an additional factor on the JSE. As part of its third-quarter style analysis, 27four has included ‘rand hedge’ and its opposite ‘rand tracker’ as risk premia in the local market.
“If you look at the typical asset manager vernacular, everybody uses the term ‘rand hedge’ quite openly,” said Daniel Page (pictured), head of quants at 27four. “We looked at what happens if you convert that to an investment style. If you sort shares on their sensitivity to changes in the rand, is there any kind of premium to be extracted?”
The shares 27four considers as ‘rand hedge’ are the 30 stocks within the top 100 companies by market capitalisation that have shown the highest currency beta over the previous 252 trading days. The ‘rand tracker’ shares, are those that have shown the lowest currency beta over the same period.
Tracking this, Page added, is particularly relevant in a market like the JSE, where a significant majority of the revenues earned by local-cap shares are in foreign currency.
“If you think of the big miners and Naspers, in particular, they have a huge amount of their revenue, expenses, even their balance sheets dictated by swings in the currency,” Page said. “So, if the rand depreciates, the miners typically do well and Naspers does well.
“So, just like for other styles – where there is an understanding that certain factors of a share dictate what its return-generating process is – we said why don’t we look at shares on the JSE that have different levels of sensitivity to changes in the rand.”
Page said there are certain dynamics that come from currency risk that are well recognised and acknowledged. It therefore makes sense to track these dynamics more closely.
“We have included it now because of the recent dynamics on the JSE. From November last year, the value play was mainly centred around mid-cap rand trackers – shares heavily tied to the South African economy. Those were the deep value shares, and they are also the shares typically hit hard when the rand depreciates against the dollar.
“What we’ve seen over the past 10 or 11 months is that some of them have done incredibly well. And with that there has been a re-emergence of the small-cap premium on the JSE.”
These interplays between risk premia are of particular interest to Page.
“No share is just one thing or another,” he said. “That’s why we look at correlations.
“You can sort shares by a particular style, but in any sort there are always shares that have weightings to other styles also. Momentum, for example, is anything that’s done well recently. That’s typically highly correlated with growth. And that’s typically been highly correlated with rand hedge.”
Similarly, what 27four labels ‘loser’ shares – those showing the least price momentum – are typically highly correlated with value.
“Those are shares that have been hit down by the market, and their prices are low relative to history,” Page said. “Prior to the Covid-19 drawdowns, you had a whole bunch of rand tracker shares – shares tied to the South African economy – that people didn’t want to hold. And so that correlation was strong.”
However, these correlations do change over time, and how they do reveals interesting dynamics in the market.
“For example, quality should – by its pure definition based on a profitability measure like return-on-assets and return-on-equity – be highly correlated to shares with low levels of volatility in earnings. That should translate into low volatility in share prices.
“But we don’t always find that. What we saw in the global financial crisis in 2008 and 2009 is that low volatility did incredibly well. But in Covid, quality did incredibly well. There was a flight to quality as people looked for companies that could withstand the storm,” Page said.
According to 27four’s analysis, factor-weighted quality on the JSE has returned 10.19% a year over the past three years. Factor-weighted low volatility has returned -6.13% over the same period.
In the recent period, however, there have been correlations between small-cap, junk (low quality) and rand tracker shares.
If one accepts that long-term returns should always be highest from the assets demanding the highest risk premium, then this makes sense.
“A paper we wrote in 2017 said that rand tracker, over the long term, actually outperforms rand hedge,” said Page. “We did that paper with data up to 2016, and obviously since then rand hedges have dominated and so that argument fell a bit flat.
“But if you look at the long term, the risk-return argument is that a rand tracker share is highly tied to our economy. That means that you have both localised idiosyncratic risk, and the risk of offshore events that can impact the South African economy.
“Typically, companies that are not just tied to the local economy, but have a diversified portfolio or naturally earn offshore with a balance sheet that is offshore-driven, are less sensitive to happenings in the South African economy. They are less risky. So, you wouldn’t expect as much of a premium associated with those shares through time.”