Currency & Sector Liquidity Analysis Report: Q3 2018

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 September 2018. The U.S. dollar posted a 2.7% month-over-month decline for the period ended Sept. 30, 2018, while the Canadian dollar lost 8.1%. Similarly, the Japanese yen (JPY) lost 65.1%, the euro (EUR) gained 538.3%, the British pound (GBP) dropped 5.3%, the Swiss franc (CHF) gained 10.0%, the Australian dollar (AUD) rose 11.7%, the New Zealand dollar (NZD) advanced 37.5%, and the Chinese yuan (CNY) fell 55.7%.

U.S. and Canadian cash on hand

Chart 2 illustrates the mean cash dollar value in sequential order from January 2018 to September 2018. The United States dollar had a net position of $3,137,653,004 for September 2018. The Canadian dollar had a net position of $3,598,346,911 for September 2018.

Chart 2 illustrates that managers took U.S. dollar profits from capital markets in February 2018. This served as an indicator of the ensuing downturn of American and Canadian markets that began during February and continued to the end of March. From Chart 1, you will notice U.S. dollar cash peaked in March 2018, from which American indices have been on a rally to the end of September 2018. The steady decrease in cash from this point onwards helps us understand the positive market sentiment and the bullish outlook portfolio managers had from this time moving forward.

Canadian markets tend to follow our peers to the south very closely. For the 12 months to the end of September 2018, the S&P 500 Composite Index is up nearly 5.21% while the TSX is down -2.46%. It is important to understand what a critical year it has been for stock markets as only a handful of geographic stock indices are still positive. The S&P/TSX Composite had also been on a rally till the end of September but has given back nearly all of its gains during October’s selloff.

The markets seemed to have reacted very poorly to highly anticipated interest rate hikes by the U.S. Federal Reserve and Bank of Canada. It seems worries over U.S.-China trade and tariff uncertainties are still outweighing the resolution of North American trade negotiations in creation of the U.S.-Mexico-Canada Agreement, which replaced NAFTA. And it seems markets pretty much ignored the World Bank’s positive forecasts for the sustainability of global growth.

Weighing on European stock indices are both the end of quantitative easing announced by Mario Draghi, the head of the European Central Bank, and the increased probability of a hard Brexit, as negotiations between the U.K. and the European Union stalled. It is no surprise to see a heavy increase in EUR cash, as portfolio managers may be looking to exit European markets in the short term. The FTSE 100 Index is down roughly -5.24% for the 12 months ended Sept. 30, 2018.

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 lists the top and bottom 10 out of 54 applicable sectors based on the mean ratio of over 3,000 investment funds with the 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 as in the case of broad level fixed income.

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.

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 constitutes another powerful tool to help make strategic and informed investment decisions.

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