In our first ever newsletter published on 4th-Jan-2021, we suggested investors initiating a short position in TLT US Equity (iShares 20+ year treasury bond ETF) via an outright short position and/or inverted risk-reversal (selling calls to fund puts on TLT). See details here.
TLT short is basically betting higher inflation expectations (the bond market will try to front run the actual CPI or PCE prints, so you want to front run the bond markets). It has played out nicely. TLT has returned circa. -12% as the US 20year yield increased by 45bps to ~2% level.
The option strategy has also worked nicely, where the current TLT price ($143) sits right between the strikes ($148 vs. $135) we chosen for the put spreads.
While you can keep the short and let the trend run for a while (or unwind the option strategy to lock in some profits), the room for further bond price decrease or yield increase might be limited to what’s already happened, because a 2.5% or 3% long term treasury yield might start to look attractive again for many bond investors and/or asset allocators, as the capital gain potential for being long bonds would become material again. That is to say, holding bonds as a risk diversifier to holding equities and other risky assets will start to come back and make sense when the 10yr treasury yield gets closer to 2%, therefore inflows or buying interests will gradually put pressure on how wide the yields can go, especially when the pandemic stimulus package start to finish.
We think it’s very unlikely for the FED to start Yield Curve Control on the longer end (>5yrs), yet the inflation expectations will continue to run hot as more fiscal stimulus keeps coming. (again, QE alone is not inflationary, but QE+Fiscal Stimulus+back-to-normal economics = inflationary).
As you have seen the volatile moves in the tech sector over the last few sessions, higher interest rates is no good news for many SaaS or growth names. In particular, it’s likely we will see below 2 trends:
The factor rotation from value to growth (even though we think it’s bad categorizing, but for the simplicity of it, let’s just use it) might continue. But there should be another rotation happening within the growth/tech sector: rotating from smaller caps/more expensive ones to larger caps/cheaper ones.
Certain sectors, such as biotechnology and softwares will likely see more worse-than-expected reportings, yet many of them are priced in near perfect executions. Due to the higher opportunity cost (more yields from fixed income or rates related sectors) and competition nature (a few winners take most of the market), sharp price corrections would be inevitable for many of them.
As growth investors, it probably makes less sense to buy into traditional energy or industrial companies. Additionally, it is actually quite difficult to analyze a lot of traditional business, given the complexity of their cost structures (do you know the break-even oil cost of a deep-sea driller?), operation risk (how to predict the production efficiency of a rare-earth mine) and global macro trends (what’s Chinese digital RMB impact on gas price).
RV trade within Tech
But constructing a Relative Value (RV) trade within the technology/growth sector, in our opinion is a cleaner trade with probably better odds to win.
Just as big tech names were the first ones to rally post March-2020, given the stability of their business and deep capital buffers,buying large tech names should be viewed as a relatively safer bet within equity when facing future uncertainty (risk off in risk on). We think more investors will rotate back to large techs to keep their growth/tech exposure while taking profits from smaller ones. This is primarily why we think Nasdaq 100 ETF (QQQ US Equity) would outperform smaller growth/tech names. Also many of large caps are actually quite cheap vs. both high flying names (those hold by ARK) and other non-tech large caps.
When it comes to what to short, it’s a little tricker. Small caps, unlike big techs,are truly back-to-normal risk-on trades: as the economy opens up post vaccine, their compressed operational activities and beaten down revenues started to see more hopes of recovering. Same cases goes for commodities .Russel 2000 had an amazing run since Nov-2020, returning 48% in less than 4 months time.
But Russel 2000 is NOT a good short when long end interest rates keep widening. Many of the underlying sectors within Russel 2000 are directly benefited from higher rates, such as Banks 7.74% and REITS 5.95%. Banks in Russell 2000 are mostly smaller regional banks. Given their much heavier reliance on mortgage business (less diversified business) compared to larger commercial banks, they are purer play on higher rates (higher margins) and will keep going as rates keep widening for this precise reason. REITS, benefiting from both higher rates (higher renting yield) and better economic activities are also not a good short against current trend.
IWM (Russel 2000 ETF underlyings)
IWO US Equity (iShares Russell 2000 Growth ETF), on the other hand, has quite different underlying risks as a very liquid small cap ETF.
IWO ( Russell 2000 Growth ETF underlyings)
Biotech, Software and Healthcare-products together account for more than 35% of the fund. Plus it has 4.12% Pharmaceuticals and 3.65% Internet among its top industry exposures. These sectors all have more downside sensitivity to higher rates because:
Biotech, Healthcare, Pharma: you might’ve heard from Cathie Wood that cheaper DNA sequencing and machine learning is a big boost to biotech and the general healthcare related names. However this is an intrinsically very difficult sector, true technology breakthrough in the medical space is rare and hard. Yes cheaper DNA sequencing and machine learning will benefit teams with industrial expertise but constrained by previous higher costs in genomics and/or ML, but many small biotech companies are burning a lot of money and only have cash to run for months, yet big pharmas might just have as much expertise but much more resources in R&D to survive out of capital droughts.
Given the high competitiveness nature, it is unreasonable to assume the entire 17% Biotech can all shine => meaning this typical “a few winners take most market” will see many failures, by the end of the day only the best drugs/medical products will see mass market adoption. IWO will suffer from its too high exposure to Bio & Healthcare & Pharma.
Similar reasons almost just apply to its software sector,, except we could actually see 12 different CRM software doing ok, and 5 different database companies all generating better revenues. But as we explained in our original TLT short idea, these very expensively priced software companies will greatly suffer higher discount rates. Furthermore, the non-exposure to Banks and REITS will mean there’s no other names to offset this suffering, making IWO much more vulnerable to interest rate moves.
How expensive are IWO software names:
Ratio Basis trade
Last but not least, we don’t just Long QQQ vs. Short IWO using 1:1 ratio. We need to balance the beta of this RV trade. A simple beta test suggests for every 1$ long in QQQ, you should short ~ 1.30$ in IWO, allowing us to be market neutral.
We also like using cash to long QQQ, and put options to short IWO, to limit downsides. Don’t be greedy, sometimes the costs are worth it.
