Delivering Alpha

Tudor portfolio manager on where she's finding alpha in the tech sector with rising rates

The Sharpe angle: Tudor portfolio manager on why she's hedging indexes over specific stocks
The Sharpe angle: Tudor portfolio manager on why she's hedging indexes over specific stocks

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With the prospect of higher interest rates looming, 2022 has already been a tough year for the tech sector. The Invesco QQQ ETF has fallen sharply year-to-date but one tech investor is braving the turbulence.  

Ulrike Hoffmann-Burchardi recently launched a new strategy within Tudor Investment Corp. called T++ with a specific focus on technology stocks. She sat down with Delivering Alpha to discuss her current hedging strategy along with where she's finding alpha in the technology sector.

(The below has been edited for length and clarity. See above for full video.)

Leslie Picker: What's it like being a tech investor right now, given this whole regime change that's really gone on in the market?

Ulrike Hoffmann-Burchardi: We have this exciting step of a next generation of digital transformation, one that is fueled by data. We predict that data is going to grow more than 100 times over the next 10 years. And this gives rise to tremendous investing opportunities in data infrastructure, in semiconductors, but also in digital and data-first businesses. So lots to be excited about. And then to the second part of your question, what is going on right now? It's less to do with the prospects of these new technologies but the fact that we have come up with unprecedented levels of fiscal and monetary stimulus. And that has led to inflationary pressures in our economy that now the Fed seeks to rein in with higher rates. 

And so with that backdrop, everything else being equal, this means low equity valuations. So we are discounting future cash flows with higher discount rates. But I think one thing that's important to recognize is that this tide of fiscal and monetary stimulus has lifted all boats, not just technology. And it's interesting to see what is still floating when this tide recedes. And here's who I still see standing: those companies with stronger secular tailwinds, the best business models, and world class leadership. And I think it's hard to find another sector that has so much of all of these. So maybe another way to put it is that the Fed can change the discount rate, but not a digital inflection of our economy.

Picker: As you see these valuations come down pretty sharply, at least in the near term, does that concern you? Are you seeing that as more of a buying opportunity?

Hoffmann-Burchardi: If you actually look at these sharp asset price corrections that we have seen, you can look at them and try to invert what these different asset classes price in, in terms of future rate hikes. And so if you look at high-growth software in particular, this now prices in a one percent increase in the 10-year rate, whereas if you look at the Dow Jones, it is still at a zero percent rate hike. So it does look like there's at least some diversity of risk being priced in. And it sounds like right now, maybe the sharp corrections in high-growth software have, at least in the short term, more to do with positioning and flows than actual fundamentals.

Picker: Paul Tudor Jones of your firm recently said that the things that have performed the best since March 2020, are probably going to perform the worst as we go through this tightening cycle. By and large, that's been high-growth technology where you spend the most of your time and look into these areas. So do you agree with that? And does that kind of concern you on the long side?

Hoffmann-Burchardi: We have to prepare ourselves for an environment with higher rates. And as you mentioned, those stocks that have cash flows that are further out into the future are more vulnerable than the ones with near-term cash flows. So with that backdrop, you have to adjust your playbook. And I do think in technology and equity investing in particular, there are still opportunities to make profitable investments in individual companies. Even if valuations are coming down, if companies outperform their growth rates, they can offset that multiple compression. And there's particular companies that are indexed to the amount of data growth. It's not that data is going to stop growing, just because the Fed stops growing its balance sheet. 

And then secondly, as I just alluded to, there could be tactical opportunities when certain asset classes overreact in the short term. And then lastly, the data also shows that it's actually sharp increases in rates that are more harmful to equities than higher rates overall. So now that we are pricing in four rate hikes this year, at least the pace of increases in interest rates should start to slow down for the rest of the year. So I would summarize that there's still two opportunities to deliver Alpha: one is stock selection and then the second one is technically adjusting your hedges when things over or underreact in the short term.

Picker: So given that backdrop that you described, what does that mean about whether technology is currently sitting at its fundamental basis? And does that give you more confidence to be a buyer in this market?

Hoffmann-Burchardi: As fundamental investors with a long term horizon our first premise is to stay invested in the companies that we believe are going to be the winners of this age of data and digital. So it's all about hedging. And, you know, hedge funds tend to get a bad rap because they're so short term-focused. But in fact, hedging can allow you to have staying power in your investments for the long term. And so in this environment, if you want to hedge out the duration risk of your cash flows, the easiest way is to offset your long term investments with maybe a basket of stocks that have similar duration of cash flows. 

However, having said that, I think the risk reward of hedging these high-growth names with other high-growth names probably has come down considerably, given that we have seen one of the largest and most furious corrections in high-growth software over the last 20 years. So it's more about then tactically adjusting your hedges, if you believe that certain assets may have overshot in this environment when others have not appropriately reacted.

Picker: What sectors are you interested in on the longer side and what sectors on the short side?

Hoffmann-Burchardi: On our long term thesis on data and digital, which we're still very early in this new era of transformation, there are really two sectors that are very interesting. One is data infrastructure, and the other one is semiconductors. And, you know, in a sense, this is very much the picks and shovels strategy of the digital age, very much like in the Gold Rush of the 1840s. And it's all about software and hardware to translate data into insights. And so for semiconductors, which is a very interesting industry, they're the digital engine room of our economy, the digital economy, and it has an industry structure that is very benign, actually has gotten better over the years. Actually, the number of publicly traded semiconductor companies has come down over the last 10 years. 

And the barriers to entry in semiconductors have increased across the whole value chain. But even the design of a chip, if you go from 10 nanometers to five nanometers, it has increased by three times. So very benign competitive framework against an end demand that is now accelerating. Even if you look at, for instance, the automotive industry, they are going to see semi content increasing by more than five times over the next 10 years. And then on the data infrastructure side, it's also very interesting. It's a very nascent market. Only about 10% of software is currently data infrastructure software. And as companies have to deal with new and large amounts of varied data, they will have to overhaul the data infrastructure. And it's incredibly sticky. It's like building a foundation of a house. Very difficult to rip out once installed.

Picker: And how about on the short side? How do you see the best way to hedge what's going on right now  in the market? 

Hoffmann-Burchardi: I think it's more hedging the risk of higher interest rates as opposed to hedge out fundamentals. And so it's just about matching cash flow duration patterns. But again, I think at this point, we're probably overdone on some of the growth software sell-off. And it's more about going into hedges that now help you price in maybe an overall slowdown on the index level, much more so than in those particular areas of technology.

Picker: Interesting, so hedging indexes, perhaps just as a way to protect the downside of the longer bets that you're doing.

Hoffmann-Burchardi: Yeah, at least in the short term. Where we have seen most of the carnage in some pockets of the markets, but others have not really reacted to this higher rate environment.