The benefits of being neutral
It is common for investors to assume that quantitative managers make extensive use of derivatives. For our mainstream long-only products this is not the case. The only derivatives used are futures, which can be purchased at the start of an investment programme to gain full exposure to the market if all the money cannot be invested on day one, without adverse market impact.
There is, however, a way in which we combine the use of futures with our market-neutral strategy that is gaining a lot of interest. Like so many investment ideas it isn’t new, it is just that the timing is propitious
Historically, one of the greatest attributes of market neutral strategies was the fact that they were actually market neutral. Indeed over the last three years in particular, as the bears have continued to suggest that the US market, for example, has been overvalued, their supporters, particularly in the private client departments, have turned to market neutral as an alternative investment strategy. The logic has been that such an approach would preserve capital in the event of the ‘expected’ market crash, but add greater value than a fixed interest investment in the meantime. In addition, because of the total return nature of the strategy we have seen market neutral develop into a new, albeit small, asset class as an alternative to cash.
At the same time institutional investors have continued to struggle with the conundrum of selecting managers, either singly or in combination, that can consistently outperform major equity markets.
For example over the past five years the median manager has only outperformed the FTSE All Share on two occasions, but in one instance it was only by two basis points and in the other a more respectable 50. The experience in the US market is equally disturbing. It is this underperformance, particularly in 1998, that has really made pension funds look at alternative ways of outperforming.
The useful thing about market neutral in this context is its low correlation with the markets. However, a caveat is necessary. A strategy resulting in equal dollar values of long and short investments is not necessarily market neutral if the underlying investments are not balanced across industry, capitalisation and other risky dimensions. A long position in banking and utilities should not be offset by short positions in steel and chemicals, because a positive (or negative) exposure to any industry or sector is risky and increases variability of return.
To achieve low volatility and to reflect only stock selection, market neutral portfolios must have offsetting long and short positions in each industry and size sector of the market. Only when the two sides are matched is the investment truly market neutral.
To the extent that this correlation is low it can be deemed to be separate or, as we term it, ‘portable’. For example over the history of our longest running US market neutral fund, the correlation coefficient with the S&P is –0.27, slightly negative. In effect the market exposure is achieved by holding futures positions in whichever equity or indeed bond market for which exposure is required.
The market neutral portfolio adds value through the skillful identification of both undervalued companies, which are purchased, and overvalued companies, which are sold short. The equity market futures overlay contributes the return of the equity market. An equitised market neutral strategy is expected to deliver an alpha relative to the market benchmark which is twice the alpha expected from a long-only equity strategy.
Because market neutral investing uses leverage, capital can be allocated to three sources of return (long stocks, short stocks and cash) which can be added to the equity market return achieved by rolling the futures contract.
An example will help illustrate the attractions of this. Our market neutral strategy has an annualised alpha over the benchmark, the 90-day T-Bill, of 3.64%. In an equitised version this portable alpha could be added to the returns of say the CAC 40, the S&P or Topix, for example. Clearly there would be a slight deduction for the associated costs, but even if it were 64 basis points, which is unlikely, an annualised outperformance of 3% would put a fund in the top decile in most equity classes.
Like all new or different approaches there is a healthy degree of scepticism from investors, but the logic is sound. The real issues are twofold: is the market neutral strategy really market neutral and does the manager have sufficient capacity in that strategy? If the answer to both these is yes, such an arrangement can be an exciting way to increase performance in all the major asset classes.
Jennie Paterson is chief executive of AXA Rosenberg Investment Management in London