Market neutral versus ‘long only’ strategies

A market neutral strategy is an investment strategy that seeks to generate positive returns in both rising and falling markets, while avoiding the inherent systematic risks of the market. Managers of market neutral strategies are focused on absolute returns rather than returns relative to an index (more common in typical long only strategies).

Market neutral strategies are sometimes confused with long/short equity funds (such as 130/30 that ultimately still have a net long position and therefore have a beta exposure). Market neutral strategies on the other hand, focus on achieving a zero beta position versus an appropriate market index to hedge out systematic risk. While market neutral funds use long and short positions, this fund category’s goal is distinctly different than plain long/short funds.

To more clearly illustrate the difference between market neutral and long only strategies, we extend our discussion from last month by looking at the performance and risk characteristics of ten well known long only large cap managers against Equus Point Capital’s (EPC) market neutral strategy.

Last month we discussed the positioning and conviction levels of ten well known active long only funds and how Equus Point was materially different. We also demonstrated that we exclude the 30 largest stocks in the index and focus more on mid and to a lesser degree small cap stocks within the S&P/ASX 200 in constructing portfolios.

The following analysis is based on disclosed unit prices with distributions reinvested and after fees (consistent with industry standards). We would note that there may be survivorship bias in the ten managers we have selected as finding well known managers with seventeen years of performance history was slightly problematic. EPC results are historically simulated and calculated on an after fee basis to ensure consistency in the comparison.

The standard approach to displaying risk is to measure the standard deviation of a fund’s returns, otherwise known as the fund’s volatility. This simply represents the variability of returns around a long term mean.

In the chart below we compare each fund’s volatility against its return for the seventeen year analysis period. The first observation is that the volatility of the active long only funds is roughly clustered around that of the index (being the S&P/ASX 200 Accumulation Index). The second observation is that most of the managers beat the index over the analysis period, some by a margin of as much as 2% per annum. This is a good result given the length of the analysis period and especially if these results are achieved with lower volatility than the index.

Over the same period EPC’s historical simulation almost doubled the return from the index, and achieved the result with only 60% of the index’s volatility.

We can extend this analysis by looking at risk adjusted returns. The Sharpe Ratio is calculated as a portfolio’s return less the risk free rate (i.e. cash) divided by the volatility of the portfolio’s returns. It simply seeks to measure returns achieved for each unit of risk.

Once again we can see a clustering of volatility and risk adjusted returns for the active managers around the index, while EPC demonstrates superior risk adjusted returns. Put simply for every one unit of risk, the EPC strategy produced 1.4 units of return above the cash rate.

At EPC we cannot avoid draw downs. But we can attempt to limit the size of those draw downs and preserve capital by putting risk management at the centre of our portfolio construction process. Limiting draw downs substantially improves the chances of investors meeting their long term goals.

Perhaps a less well used chart is beta versus correlation. Once again we have clustering of our ten managers just below a beta of 1.0, with correlation of 80% or higher. Because EPC deliberately hedges out residual beta exposure in its long and short portfolio it has a beta of close to zero over the long term. A similar result is demonstrated for EPC’s correlation with a result less than 10%.

Perhaps the best way to demonstrate the relationship between long only returns and the index is a regression analysis. In the chart below we compare the monthly index return and the average return from our ten managers. The regression analysis suggests the average manager return is 96% correlated to the index.

EPC’s regression analysis is significantly different. It demonstrates that the returns are uncorrelated to the performance of the index. Overall EPC produces average positive returns in both up markets and down markets. Put simply EPC might not participate fully on the upside when market returns are strong, but similarly the strategy will tend to avoid large negative returns when market returns are weak.

Lastly we rank monthly returns from lowest to highest for EPC, the average of our managers and the index. Note how the curve of the average of our ten long only managers closely matches that of the index. Once again this is a reflection of the high beta and correlation between the average manager and the index.

With EPC we may not participate fully on the upside when index returns are at their positive extremes, but we also tend to avoid the pitfall of large negative returns. At EPC we attempt to limit the downside return outcomes and preserve capital.

In summary a market neutral strategy like Equus Point Capital deliberately seeks to hedge out systematic market risks (i.e. beta). In so doing, we can generate a return stream over the long term that is uncorrelated to the market, will perform in both up markets and down markets and preserve capital. These attributes can provide investors with a superior risk adjusted return outcome than typical long only managers that are heavily exposed to the whims of market movements.