Despite the name, there’s nothing middle-of-the-road about the returns that market neutral funds can generate.
The collapse of Long-Term Capital Management and the activities of George Soros and other so-called momentum investors have given hedge funds a bad reputation in the last few years. But this reputation is unwarranted and in volatile markets some hedge funds are attractive, one such category being ‘market neutral funds’.
Unlike most traditional investment managers, market neutral managers seek to generate positive returns regardless of the financial markets’ movements. There are many ways to achieve this but we have chosen to concentrate on a relatively specific area – ‘long-short equity market neutral funds’. By running long and short portfolios, managers aim to remain neutral from any market movements and they must be skilful at identifying underpriced and overpriced shares to achieve this.
Double alpha returns
A market neutral manager constructs a portfolio of under-priced shares expected to outperform and sells short a portfolio of shares expected to underperform. He can then buy these shares back at a profit when their value has fallen. The market exposures of the two portfolios are designed to cancel one another out leaving the profit from the two sets of stock decisions, hence the term ‘double alpha’ describing this doubling of performance.
It is questionable whether a market neutral fund qualifies as a hedge fund. According to most definitions, a hedge fund relies upon skill rather than market returns to generate an income, sometimes using leverage to do it and mostly investing in illiquid assets. Because market neutral funds involve short selling they could be classed as hedge funds. But the portfolios are also highly structured and in this respect they differ markedly from those hedge fund managers that have the discretion to invest in whatever asset class they please. In addition, they are geographically constrained and possess other characteristics that more closely resemble institutional products.
However you define market neutral managers, they are not suitable for everyone. European pension funds interested in this investment area need a thorough understanding of their fund’s appetite for risk and return. Moreover, market neutral funds should only be used as part of a carefully thought-out investment strategy and, once implemented, they need monitoring by an appropriate governance structure. However, for those pension funds comfortable with the concept, market neutral funds have the benefit of strong return characteristics and the advantage of independence from mainstream markets making them useful for diversifying risk.
We have researched market neutral funds for the last two years and to date we have visited 20 or more managers to understand their investment processes more clearly. In particular, we try and establish whether or not the individuals running the fund have the requisite skill to continue generating high returns and to understand the level of risk they incur in doing this.
Off the beaten track
Most traditional equity funds quantify the risk they run in terms of tracking error – the deviation from any stock market index they use as a benchmark – and market neutral funds are no exception (they could either be a cash or a futures index, if equitised.
While most traditional funds have tracking errors of 2 or 3%, market neutral funds may have tracking errors of 5 to 10%. If a two standard deviation event occurred (the likelihood being 1 in 20), a market neutral fund with a tracking error of 7%, for instance, would deviate from its benchmark by 14%. Hopefully, it would show an outperformance of 14%, but it could also be an underperformance of 14%.
There are also size constraints to consider when investing in market neutral funds. Performance may deteriorate once assets under management pass a certain threshold. Our research shows it may be as low as $1bn and we would certainly start asking questions if assets under management were to approach $2bn. There are two reasons for this. First, once a fund reaches a certain size, trading costs tend to increase quite significantly as a percentage of funds under management. Secondly, the liquidity of individual stock positions begins to decrease, which can damage the performance of a fund relying on the ability to sell positions quickly.
Performance costs
Market neutral funds can also be costly to run. Because they seek immunity from market movements, their long and short portfolios undergo constant re-balancing and this incurs considerable transaction fees. The managers therefore need to be highly skilful, not only to jump the cost hurdle, but also to generate sufficient outperformance.
Having said this, market neutral funds undoubtedly possess many attractions. A handful of our clients in the UK and continental Europe have already started investing in them. As they gain greater acceptability amongst institutional investors, this trend looks set to continue.
Tim Hodgson is a senior investment consultant with Watson Wyatt in the UK