C8 Monthly Update – Water Risk and Private Equity Metrics – June 2020

Thomas Schumann Water Risk Index

Nearly a third of the world is already subject to water stress, a burgeoning issue that will worsen under the impact of climate change, and as population growth fuels increasing water demands. The effects of water access changes on businesses will create winners (those who manage water well) and losers (those who mismanage water resources). The Water Risk Index takes these environmental risks into account in the portfolio selection.

This portfolio selection is powered by Equarius Risk Analytics (ERA), founded by Dr Peter Adriaens who is Director, Center for Smart Infrastructure Finance, The University of Michigan and a world-leading expert on water risk.  ERA methodology uses AI and machine learning to analyse a company’s geographical and other exposures to water risk, providing a ‘waterbeta’ for each company. Thomas Schumann Capital, with the help of index provider Fuzzy Logix, then use this waterbeta to build the Water Risk Index portfolios. A EUR Index has been launched, with a US version to follow shortly.  We are delighted to announce that the Water Risk Indices will be available to be tracked on C8 Studio.

Water Risk Index EURO 50 Performance

Since 2010, the Thomas Schumann Water Risk Index EURO 50 would have outperformed the EuroStoxx50 by 15 percentage points by integrating physical and financial water risk into investment decisions.  It also seems likely to us that the investment impact of Water Risk will grow over time.

Taking Private Equity Metrics From Efficient Alpha Capital

We are also delighted to add two Indices from Efficient Alpha Capital (EAC) this month. Efficient Alpha was founded in 2016 by Doug Scherrer. Doug has over a decade of Private Equity investment experience: beginning at General Atlantic, one of the largest ‘growth equity’ investment firms in the world, and more recently at ClearLight Partners, a lower-middle market buyout fund based in Southern California. In between his time at those two firms, Doug was the Chief Financial Officer of Nubank, a Fintech start-up based in Brazil, which today is the largest digital bank in the world with over 25 million customers.

EAC investment strategies are based on the powerful idea that fundamental financial methodologies used to evaluate Private Equity investments can also be applied to the public markets. Two Indices from EAC are available on C8 Studio: 

  • Free Cash Flow: Private Equity investors are generally attracted to companies that generate strong Free Cash Flow. These companies tend to have high profit margins, low working capital requirements, and low capital expenditures – and also tend to be more resilient amidst volatile macroeconomic conditions.
  • Deferred Revenue: Deferred Revenue is created on a company’s balance sheet when it receives an “upfront” payment from a customer. Private Equity funds like to invest in this type of company for two main reasons. First, upfront payments result in improved cash flow generation. Second, being able to charge customers prior to the delivery of a product/ service is generally a ‘signal’ of a company’s competitive differentiation.

With the help of index provider S-Network, EAC has created two portfolios based on these Private Equity metrics.  C8 has then taken these portfolios and added a quantitative equity L/S overlay strategy. This overlay weights the portfolio by factors such as growth, size and value, rather than market cap, and adds a leveraged Long/Short element (with the short the S&P 500 TRI). The combination of this high-quality equity portfolio and the quant overlay would have generated consistently good performance over the 12 year sample period – strong returns with low volatility.   We show the performance below:

C8/ Efficient Alpha – Free Cash Flow

C8/ Efficient Alpha – Deferred Revenue

C8 Direct Indexing now Available on Interactive Brokers

We often discuss new Indices and enhancements to C8 Studio in this Update, but, of course, just as important in making Direct Indexing a straightforward and seamless experience for our clients is our execution platform, C8X. For three separate client implementations, we have entered into a collaboration with Interactive Brokers (IB) to complete the FIX integration between C8X and their trading ecosystem.

Each of our new clients is now able to re-balance their Index portfolios themselves, at the click of a few buttons, pulling in the required re-balancing trades for the underlying assets, then executing them using the DMA (direct market access) capabilities of IB, with the trade executions feeding directly into their IB accounts. No matter how many Indices are being subscribed to, the whole re-balancing process only takes a few minutes, with no trade entry or booking required.

May 2020 Performance

The sharp bounce back in equity markets continued in May, with our ‘long-only’ equity Indices performing well, whilst our L/S and Stat Arb Indices also performed strongly, not least the new Free Cash Flow L/S (discussed above) which was up 7% in the month.  However, our sample FX risk premia combo gave up some of its recent gains, whilst commodities ARP have still to find their feet after recent market dislocations.  China commodity ARP however bounced back as Chinese markets stabilised post-lockdown.

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