More and more portfolio managers try to eliminate market risk. Often enough, they even succeed.
By Laurie Kaplan Singh
July 2001
Institutional Investor Magazine
More and more portfolio managers try to eliminate market risk. Often enough, they even succeed.
On paper, at least, it's a pretty picture: consistently positive returns that don't rely too heavily on stock and bond market performance. That's the clear appeal of a market-neutral strategy. Although it's hardly infallible, this investment approach is meeting its objective often enough to entice a growing number of portfolio managers and investors worldwide. In today's edgy global markets, it's little wonder.
"We've been doing this for 12 years, and we are seeing more interest in market-neutral strategies than ever before," says Mark Steen, director of research at Blue Rock Advisors, a Minneapolis-based fund-of-funds manager that specializes in equity market-neutral strategies.
At the end of the first quarter, the category claimed about $24.3 billion in assets, up from $21 billion a year ago.
"We have experienced impressive asset growth over the past 15 months," says John Gottfurcht, president of the 28-year-old SSI Investment Management, one of the oldest market-neutral firms, whose assets grew from $450 million to $650 million.
With the easy gains of the late '90s now just a sweet memory, "investors are increasingly interested in absolute return strategies with low volatility and a low correlation to the broad stock market," says Robert Furdak, director of portfolio management at Cambridge, Massachusetts-based Numeric Investors, a leading quantitative market-neutral manager.
Furdak and his colleagues have produced solid returns, but, not surprisingly, they lagged the Standard & Poor's 500 index during the go-go '90s. According to Chicago-based Hedge Fund Research, whose market-neutral index includes a variety of strategies, the average market-neutral hedge fund returned an annual 11.3 percent over the ten years ended May 31, versus 12.9 percent for the S&P 500. At the same time, the average fund reported a standard deviation of 3.3 percent and a correlation to the S&P 500 of 14 percent. In contrast, the average long-only equity fund shows a standard deviation of 14.8 percent and a correlation to the S&P 500 of 76 percent.
The term "market neutral" covers a host of investment strategies, including convertible and merger arbitrage, that are designed to produce returns independent of stock and bond market performance. The most precise definition, according to SSI's Gottfurcht: a portfolio of long and short securities that eliminates, as much as possible, all market-related risk, known as beta, leaving behind only the component of return that reflects a manager's securities selection skill, or alpha. The strategy involves investing one dollar short for every dollar long and matching the attributes of the long and short positions to minimize style (for example, value or growth), size (market capitalization) and sector biases.
"We want our excess return to come from pure stock selection," says Gottfurcht. Essentially, market-neutral managers attempt to capture the spread between the fund's long and short positions. "They are betting that the fund's long positions will outperform the shorts," Blue Rock's Steen explains. Given their emphasis on low volatility, market-neutral funds generally do not use leverage.
The rebate, or interest income, earned on the proceeds from the short stock sales provides another important source of return for market-neutral portfolios. "Because a large component of their return generally consists of interest income, most market-neutral portfolios have an implicit hedge against rising interest rates," says Robert Fullerton, president of Blue Rock Advisors. "This contributes to the strategy's low correlation with traditional stock and bond portfolios," he says.
Stock-picking styles differ among portfolio managers. "Every manager's stock selection is unique, and there is no specific stock selection discipline that is going to work in every environment," says Steen. He divides the universe of approximately 80 equity market-neutral funds into four categories based on their stock selection disciplines: quantitative, fundamental, industry specific and region specific. Even within each category there are significant differences among managers, and many blend one or more of these approaches.
Beverly Hills, California-based SSI uses a quantitative stock-screening process to identify under- and overpriced securities. It then carefully examines all potential candidates for both the long and short sides of the portfolio using in-depth fundamental analysis to assess each company's financial strength, profitability and competitive advantages. SSI also matches the characteristics of its long and short positions to ensure that its portfolio is free of sector and style biases.
Since 1984 SSI's market-neutral strategy has generated an average annual return of 9.18 percent, with a standard deviation of 5.87 percent, versus 15.3 for the S&P 500. Recent refinements to SSI's stock selection process, which include the spreading of stock selection responsibility to six managers instead of one and the addition of a supplementary model for identifying overbought and oversold stocks, have allowed the firm to improve its returns over the past four years. Since 1996 it has consistently produced annual returns in excess of 11 percent while keeping its standard deviation below 6 percent. Last year SSI's market-neutral portfolio was up 15.9 percent, versus a decline of 9.1 percent for the S&P 500.
Unlike most market-neutral managers, New York-based Artemis Investment Management avoids a quantitative approach. Instead, it deploys a strategy commonly known as "pairs trading." The fund's managers use relative value analysis to build the portfolio from the bottom up, taking positions in pairs of stocks. Each pair consists of a long position in a stock that, based on management's fundamental research, is expected to outperform and an offsetting short position in a stock with similar characteristics that the fund's managers expect to underperform.
Ivan Thornton, who oversees client services and marketing for Artemis, recalls that last December the fund took a long position in Consolidated Stores Corp. and an equally dollar-weighted short position in Tiffany & Co. Over the next two months, Consolidated Stores appreciated 32 percent, Tiffany dropped 9 percent, and the fund captured a 41 percent return on the trade.
Since the fund's October 1998 launch, Artemis has produced impressive results. It racked up an average annual return of 16.6 percent, net of fees, while exhibiting zero correlation to the S&P 500. "An important objective of our strategy is to produce returns that have absolutely no correlation with the stock market return," Thornton says.
Paris-based Sinopia Asset Management offered a new twist in March when it introduced the Alternatime Fund, a fixed-income market-neutral product designed as an alternative to shorter fixed-income securities with maturities between one and two years. The fund, which seeks to generate an annual return between 200 and 300 basis points over the effective euro overnight rate (EONIA), invests in a portfolio of sovereign bonds and futures on sovereign bonds of the 22 developed nations in the J.P. Morgan broad government bond index. The portfolio is structured to capitalize on the firm's expertise in using proprietary modeling techniques to identify pricing inefficiencies in the interest rate markets and to forecast the direction and timing of interest rate changes, while neutralizing as much as possible all other risks normally associated with fixed-income instruments, including duration, currency and credit risk.
Sinopia mitigates these risks by carefully matching the currency and duration characteristics of the long and short sides of the portfolio. "We are taking a view on the long-term direction of interest rates, but we are not making any yield curve bets," explains managing director Leon Chautin. Since its debut on March 1, the Sinopia Alternatime Fund has returned 1.34 percent, or about 20 basis points over EONIA. Currently, the fund is available only on an unleveraged basis and denominated in euros, but at the end of June, Sinopia was slated to offer yen- and dollar-denominated versions of the same portfolio, as well as a leveraged version of the fund denominated in either yen, dollars or euros.
Capitalizing on the low correlation of returns among market-neutral funds, Blue Rock Advisors specializes in multimanager funds-of-funds dedicated to the equity market-neutral strategy. Its flagship product is composed of 12 different equity market-neutral portfolios, including highly quantitative funds, funds with a greater emphasis on fundamental research and industry-specific and region-specific funds.
"The key is that all of these funds use different stock selection disciplines, and as a result, they have a very low correlation to each other and tend to perform well at different times," Fullerton says. During its ten-year history, the unleveraged fund-of-funds has produced an average annual return of 10.57 percent and a standard deviation of 2.84. Says Steen, "The fact that the individual managers pursue very different approaches allows us to obtain significant diversification and generate consistently positive returns."
And that's what investors want.