Equus Point Capital Market Neutral Fund in a diversified portfolio

The benefits of uncorrelated assets and strategies

A market neutral strategy should provide meaningful diversifying benefits for investors given the expected low correlation to the underlying equities market.

Market neutral is often mistakenly as assumed to be negatively correlated. The fact that the equity market has a negative month does not imply a market neutral strategy will produce a positive return. This would imply the strategy is negatively correlated. Rather market neutral should be considered as uncorrelated to the equities market over the medium to long term, notwithstanding the potential for periods of both positive and negative correlation to equities in the short term.

There will be periods from time to time when market neutral strategies will not perform well. No investment can legitimately claim to perform at all times in all market conditions. This reflects the need to have a diversified portfolio with exposure to a range of assets and strategies that will perform through various market cycles.

One of the aims of diversification is to reduce volatility outcomes and improve overall risk adjusted returns. This can be best achieved through combining assets that are largely uncorrelated. Put simply when a particular asset within a portfolio performs poorly other assets will generally help to smooth out portfolio returns.

Let’s walk through an example of how uncorrelated assets can add value and reduce risk.

In the following example we have two stocks, Fortescue (FMG AU) and Xero (XRO AU). Fortescue is a well recognised iron ore producer and exploration company with assets located in the Pilbara region of Western Australia. Xero provides a platform for online accounting and business services to small businesses through a range of cloud accounting software.

Clearly Fortescue and Xero have very different businesses with different macro factors impacting the behavior of the respective share prices. Fortescue is driven by changes in the price of iron ore. Xero is driven by the growth of its cloud based software across multiple markets. Of course there is the overall need for both businesses to manage costs etc., but the businesses are fundamentally different.

In the three years to June 2019 Fortescue and Xero had generated similar returns of 55% and 54% per annum, respectively. A pretty good outcome when compared to the S&P/ASX 200 Accumulation Index which returned 13.9%pa over the same three year period. These returns were generated with volatility of 39% and 30% respectively.

 

More importantly while the two stocks produced similar returns the journeys were quite different. In periods where Fortescue performed strongly Xero performed modestly and vice versa. When looking at the correlation between these two stocks – that is a measure of the extent to which they move in unison – the correlation was a mere 0.10. This means that over the three year period under study Fortescue and Xero were essentially uncorrelated. This is not surprising given the substantial differences in their underlying drivers we noted earlier.

However, when we combine these two stocks in equal weight we witness the power of adding uncorrelated assets to improve portfolio diversification.

The first item to note is the volatility of both stocks at more than 30%. Whilst index volatility has been 10.6% on over the analysis period, individual stock volatility can be a lot higher. In fact many investors might be surprised to discover that the average individual stock volatility is close to 30%.

The uncorrelated nature of the two stocks’ return streams demonstrates the power of diversification. By adding two uncorrelated stocks with similar volatility characteristics we can substantially reduce the overall volatility of the combined positions without impacting overall returns. The volatility of the combined portfolio is 28% compared to the average individual volatility of 35%.

 

Risk Reduction

A portfolio’s systematic risk cannot be eradicated completely, but it can be mitigated through the careful allocation of funds to a broad range of assets. Provided the assets are not highly correlated a diversified portfolio should reduce the overall volatility of returns and smooth investment returns over the long term. However, one should be mindful that in volatile and negative markets the correlation between assets tends to increase, thereby reducing some of the expected benefits of diversification.

We believe any strategy that is included in a diversified portfolio should have low correlation with the existing assets in the portfolio, providing very clear diversification benefits and reducing portfolio risk.

To demonstrate the non-correlated nature of the Equus Point Capital Market Neutral strategy, the following correlation matrix compares the strategy against a range of well recognized indices from June 2000 to May 2019. The Equus Point Capital strategy exhibits low or negative correlation to each of the alternative assets, clearly demonstrating its potential to add attractive diversification benefits to investor portfolios.

 

Capital Preservation         

Downside moves tend to be sharper and more violent than upside moves. Remember also that a loss of 50% in the value of an investment requires a subsequent 100% return to restore the investment to its original value. This example reflects the events of 2008 and where the local share market lost 47% in value (including dividends). These losses took more than six years to recover, although in a pure capital sense the market remains more than 10% below its 2007 peak at the time of writing.

We view capital preservation as one of the keys to successful long term investing and achieving optimal investment outcomes.

By way of example, the following illustrates the draw-down of the Equus Point Capital Market Neutral strategy against the S&P/ASX 200 Accumulation Index from June 2000 to May 2019. The Equus Point Capital strategy clearly preserves capital over the long term through shallower draw downs, and avoided the near halving of the index during 2008.

Alternative assets area broad church that can include long/short equity, distressed debt, private equity, direct property and infrastructure, to name but a few. Each of these has their own risk, return and liquidity characteristics. Ideally alternative assets should provide some protection for an investor, such that when more traditional assets do poorly, alternative assets provide valuable diversification.

While alternative assets can be beneficial to a portfolio it is important to consider the liquidity characteristics of any investment.

The Equus Point Capital Market Neutral strategy provides liquidity by only investing in listed shares that are members of the S&P/ASX 200 and avoiding the least liquid shares within this share universe. In addition the strategy uses liquid index futures to manage residual beta risks.

 

What is a market neutral strategy?

A market neutral strategy attempts to provide a return stream that is independent of the underlying equity market. This is achieved through buying stocks (long exposure) and selling stocks (short exposure) with the aim of removing or neutralizing exposure to the general market. In doing so the strategy seeks to add value irrespective of market direction.

There are however some key considerations when assessing the attributes of an equity market neutral strategy:

 

Equus Point Capital within a diversified portfolio

Equus Point Capital Market Neutral Fund is designed to provide a return stream uncorrelated to traditional asset classes and preserve capital in volatile negative markets. Given the low correlation of the return stream through the cycle it should provide meaningful diversification benefits within a broader portfolio.

In the following case study, we have taken a standard asset allocation for a balanced fund and added a 10% allocation to the Equus Point Capital strategy. The remaining assets have had their respective allocation reduced on a pro rata basis. We would note that there is some debate about whether an alternative strategy, such as a market neutral strategy where the benchmark is typically cash, should be treated as an equity allocation or a fixed interest allocation within a broader portfolio. In fact it is neither. Market neutral strategies truly represent an alternative to traditional asset classes.

The analysis adopts well recognized indices and adjusts the returns to reflect management fees for local ETF’s to ensure an after fees return is generated. Rebalancing back to a strategic benchmark is conducted annually. The period of analysis is from June 2000 to May 2019. The Equus Point Capital strategy adopts a 1.2% management fee and a 20% performance fee above a hurdle of the RBA Official Cash Rate (with a high water mark).

Adding just 10% allocation to the Equus Point Capital strategy would have added 90bp in additional return after fees and reduced volatility by 10%. It would also have almost doubled the Sharpe Ratio and reduced the draw down by 20%.

 

 

 

Adopting a sensitivity analysis by varying the allocation to the Equus Point Capital strategy we can demonstrate that for a ‘Balanced’ portfolio a higher allocation than the suggested 10% would improve risk adjusted returns and draw-downs further.

The analysis above is based on the historical return and risk characteristics of the underlying asset classes and that of the simulated Equus Point Capital Market Neutral strategy. Going forward care should be taken in assuming historical return and risk characteristics are representative.

 

Summary

Seeking out and implementing truly uncorrelated assets and strategies can provide meaningful risk adjusted returns to investor portfolios. Uncorrelated strategies assist in reducing portfolio risk, thereby improving risk adjusted returns. They can also assist in reducing draw-downs during times of market stress.

Market neutral strategies provide a return stream uncorrelated to traditional assets and provide real diversification benefits. There are however a range of key considerations when assessing a market neutral strategy.

Equus Point Capital’s Market Neutral strategy delivers a balanced and uncorrelated return profile that can provide attractive diversification benefits within a broader portfolio.

 

Notes:

 

The material contained in this communication (and all its attachments) has been prepared by Equus Point Capital Pty Ltd. Equus Point Capital is a Corporate Authorised Representative of Prodigy Investment Partners Limited AFSL No. 466173 (“Prodigy”). 

You should not act on any recommendation (if any) made in this communication without first consulting your investment advisor in order to ascertain whether the recommendation (if any) is appropriate, having regard to your investment objectives, financial situation and particular needs. Nothing in this communication shall be construed as a solicitation to buy or sell a security or to engage in or refrain from engaging in any transaction. 

Equus Point Capital and Prodigy believe that the information and advice (if any) contained herein is correct at the time of compilation.  However, Equus Point Capital and Prodigy make no representation or warranty that it is accurate, complete, reliable or up to date, nor does Equus Point Capital or Prodigy accept any obligation to correct or update the opinions (if any) in it. The opinions (if any) expressed are subject to change without notice. Equus Point Capital and Prodigy do not accepts any liability whatsoever for any direct, indirect, consequential or other loss arising from any use of the material contained in this communication. 

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