Global equities
15 Mar 2019

Re-engage with equity market neutral

Investors should re-engage with equity market neutral as an uncorrelated investment strategy able to enhance risk adjusted returns.

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The calendar year 2018 marked the re-emergence of index level volatility for global equities as an asset class. It followed an extended period of accommodative monetary policy and low interest rates, coinciding with a near 10 year bull market in global equities.

During this 10 year period there was a proliferation of purportedly uncorrelated investment strategies variously labelled as ‘liquid alternatives’ and ‘absolute return’ funds. Alongside the diversity of underlying investment strategies, was a diversity of investor expectations of return outcomes from these strategies. Given the economic and financial backdrop of the decade after the global financial crisis (GFC), it is perhaps unsurprising that genuinely risk controlled, liquid investment strategies, which consistently demonstrated uncorrelated returns, attracted flows from a very wide variety of types of investor. Some investors sought fixed income substitution, in an environment starving for yield; others sought a tactical short term home for cash, with bank deposit rates at rock bottom. Latterly, with the return to a high cross sectional volatility environment in 3Q and 4Q 2018, others seek downside protection.

In the aftermath of the market regime change and enhanced index volatility, which characterised calendar year 2018, the return outcome of many such strategies has come under renewed scrutiny. At the same time, the unwinding of the most prolific global monetary stimulus in modern economic history has caused some market participants, conditioned to a negative real yield environment, to challenge both the relevance and role of equity market neutral strategies.

Return outcomes for equity market neutral strategies in 2018 were generally less robust relative to experience over recent calendar years. The effects of divergent regional monetary policy increased the attractiveness of cash to dollar denominated investors. Concurrently, the pronounced oscillation between risk on and risk off, fuelled by 24/7 news flow and unregulated (anti-) social media, have led some market participants to question the future efficacy of such uncorrelated investment strategies.

However, it is precisely during periods of frustration, or disappointment around performance outcomes, and more particularly around ‘perceived’ outcome expectations, that investors face an increased risk of succumbing to behavioural biases, such as an overreaction to short term performance. As a team we are acutely aware of such tendencies, given that a significant proportion of our alpha generation consists of identifying inefficiencies and mispricing wrought from behavioural biases and tendencies often exhibited by market participants.

This paper aims to show the importance to investors of the core principles of equity market neutral as one of the most established and consistently robust uncorrelated investment strategies, capable of genuinely enhancing investors’ risk adjusted returns. With index level volatility once again normalising in an environment of quantitative tightening, harnessing a return source that is both demonstrably independent of equity markets, and capable of navigating downside risk is arguably more relevant to portfolio construction than at any time during the past five years. We shall firstly present the empirical and statistical case underpinning the assertion that equity market neutral represents a universally adaptable investment strategy. We shall then reaffirm the continued relevance of genuine equity market neutral strategies in mitigating systemic risk, particularly in the aftermath of recent regime changes across the broader market.

In the context of the recent regime change, it is worthwhile revisiting the core principles behind equity market neutral strategies, as we move out of the era of quantitative easing (QE). Particularly given that the QE era has been associated with a surge in passive and index type strategies, it is only right that we question whether this effect has eroded away the informational advantage of more established uncorrelated investment strategies. In a similar vein, the narrative around the ‘democratisation’ of factor investing highlights how the crowding effect in certain areas of the market may have further reduced the opportunity set for such strategies. Upon revisiting the rationale for equity market neutral investing, it is refreshing to learn how the weight of empirical and statistical evidence continues to substantiate the strategy’s ability to generate returns that are independent of market direction, by profiting from both long and short ideas, while ensuring dollar and beta neutrality.

Corroborating this position, the table below shows the return correlation of traditional asset classes1 to alternative hedge fund styles, using the HFRI hedge fund indices, both since inception2 and for the last five years. While diversification to bonds comes easily across all hedge fund styles only global macro and equity market neutral styles offer anything like uncorrelated returns to equities. The Merian Global Equity Absolute Return Fund (GEAR) has considerably lower correlation to traditional assets than both our peer group, and other hedge fund styles.

 

Source: MGI as at 30/12/2018

Equity market neutral as an investment strategy seeks to limit exposure to systemic changes in asset pricing caused by shifts in macroeconomic variables or investor idiosyncrasies. Typically this is achieved by taking offsetting long and short positions in instruments with actual or theoretical relationships. In effect, the strategy strives to generate consistent returns in both rising and falling markets, through selecting positions with a total net exposure of zero.

The end result is not just uncorrelated returns, it is performance when it is needed most. Below we see the average monthly returns of the above asset classes and indices when equities experience positive and negative returns. Over the full sample, equity market neutral is the only strategy insulating from market falls with results being consistent in the most recent five year sub period. The Merian Global Equity Absolute Return Fund has offered a positive return in both environments, in both sample periods.

 

Source: MGI as at 30/12/2018

The expansive return series upon which this empirical and statistical evidence is predicated warrants some caveats. Historical events may not necessarily repeat owing to limitations in data, or to the time varying effects of outcomes over discrete periods of data. However, with the benefit of 24 years of return series including several full market cycles, not to mention the GFC and an extended period of QE, there exists a rich and diverse data set from which to gain multivariate insight into the interaction between asset classes. At the same time, it is difficult to empirically and robustly examine the hypothesis that ‘this time it is different’ without examining a more recent subsample of data. Here we find evidence across the two subsamples examined offering very little consistent support for a hypothesised structural change.

While historic returns for asset classes may be susceptible to time varying or regime specific effects, and by extension more difficult to forecast, volatilities and correlations, by contrast, have characteristically proven more stable and sustainable through time – and, by virtue of this, more predictable through time. From a quantitative perspective, this is something we can attempt to model, and to obtain a forecast outcome.

Comparisons to other alternative investments provide one petri dish by which to examine the benefits of investing in equity market neutral funds. However, it is possibly more important to examine the benefits they provide in excess of traditional assets, which typically make up the vast majority of investor holdings. An historic analysis of incorporating equity market neutral to a global equity portfolio reaffirms the benefit of equity market neutral strategies in enhancing risk adjusted return outcomes.

As an initial benchmark, the efficient frontier from a portfolio allocating to MSCI regional equity indices is constructed constraining weight in each regions to be a maximum of 30% to ensure a diversified, realistic portfolio3. The graph below shows the impact to the efficient frontier of including an allocation of the HFRI Equity market neutral index in 10% increments. This methodology highlights the set of possible portfolio allocations which maximise expected returns for a given level of risk. In effect, the same return would have been achieved with lower volatility by increasing the allocation to equity market neutral investments.

 

Source: MGI as at 30/12/2018

In the second analysis, we incorporated fixed allocations to bonds alongside equities and equity market neutral, extending our analysis to an asset allocation setting. The equity/bond portfolio has a fixed 30% weight to the FTSE World Government Bond index and 70% allocation to equities with similar constraints to the prior equity analysis4. Again the same level of return would have been achieved with lower volatility through increasing the allocation to equity market neutral as an asset class. It is possible to observe that the critical impact remains in the lower to medium risk return area; albeit within such areas the impact in terms of enhancing risk adjusted returns can be meaningful.

 

Source: MGI as at 30/12/2018

In light of the different sources of returns derived respectively from stocks, bonds and equity market neutral strategies, the ‘efficient frontier’ highlights how variability in overall portfolio volatility may be dramatically reduced without suffering a proportional decrease in returns. Looking at the allocations of portfolios at the efficient frontier, we can see the optimal allocation to market neutral increases almost monotonically as one goes from the highest risk portfolios, which have a small allocation to market neutral of 1%, towards medium risk portfolios, with an allocation to market neutral of around 20%, while the lowest risk portfolio has an allocation which we limit to 30%.

 

Source: MGI as at 30/12/2018

Of particular note, if we compare the unconstrained efficient frontier between a two asset equity, bond portfolio and a three asset portfolio including the HFRI equity market neutral index increased allocation to market neutral strategies would have produced a higher return than that achieved from bonds, while incurring less risk5

 

Source: MGI as at 30/12/2018

Finally, the marginal return for a given level of market risk incurred (Treynor ratio) is examined through incrementally moving allocation from equities to bonds, the HFRI Equity market neutral index, or the Merian Global Equity Absolute Return Fund. Using data since the inception of GEAR, the Treynor ratio is improved firstly when allocating to equity market neutral rather than bonds, and secondly through allocating to GEAR over the HFRI representative peer group index.

 

Source: MGI as at 30/12/2018

In contrast with the previous analysis which demonstrates how well equity market neutral funds reduce total risk, here it is shown they also have the ability to diversify equity market risk, commonly the largest source of risk within traditional equity bond portfolios. In essence the impact of this equity market neutral strategy offers

returns that are higher than those of fixed income, but with a lower volatility profile than equities. As we have frequently highlighted, the hedged nature of the GEAR strategy frequently sustains positive performance during episodes of negative stock market performance.

Equity market neutral strategies clearly do not eliminate risk entirely; rather they allow investors to hedge unwanted risks and to retain exposure to risks they wish to maintain. As with all investment strategies, there will be environments which are more conductive to the process, and less frequently there will be environments which are less conductive to the process. Market neutral strategies are intended to trade exposure to the market for exposure to the relationship between the long and short sides of their portfolio. Relative value investing takes a non-directional approach, with returns coming from the net result of the long and short components. Performance is decomposed between the long book, relative to a long index, and the short book, relative to a short index. As such, the risk to an equity market neutral strategy is relative stock picking risk rather than an absolute stock picking risk. As set out above, we have conviction (based on evidence) in the relevance and value of an equity market neutral strategy in enhancing risk adjusted returns in a diversified portfolio; it has proven its consistency and uncorrelated effect through different market cycles and in diverse market conditions.

Arguably in the aftermath of the regime changes which took place in 2018, the power of the strategy better to mitigate idiosyncratic risk makes an allocation to portfolio more relevant today, given the profound geopolitical and macroeconomic risk embedded in the real economy. Finally, we believe that the robustness of our investment platform, together with our prioritisation and focus on research, makes our proposition ideally placed to mitigate those risks more generally levelled at the investment strategy, such as adaptability and responsiveness to regime change. Our expectation is that the fund should continue to provide diversification over the medium term against equity market moves, as it has done historically. Our expectation for performance over the medium term continues to be positive, both under a continuation of the current uncertainty and also if the environment becomes more benign.

Source:

1 MSCI AC World index is used for equities, and the FTSE World Government Bond Index for bonds. The 60 40 Portfolio is a 60%, 40% weighting of these two indices rebalanced monthly. All returns are monthly total returns.

2 January 1995 for the HFRI Indices, June 2009 for GEAR. Data used up to and including December 2018 with last five years being the period 2014 – 2018.

3 The portfolio is comprised of MSCI North America, MSCI Europe, MSCI Japan, MSCI AC Asia excluding Japan and MSCI Emerging Markets. Expected return and risk estimates are calculated using monthly total returns over the full sample period of January 1995 to December 2018.

4 The equity component of the portfolio is comprised of MSCI North America, MSCI Europe, MSCI Japan, MSCI AC Asia excluding Japan and MSCI Emerging Markets with each region having a maximum allocation of 30%. For bonds we have a fixed 30% allocation to the FTSE World Government Bond Index. We choose a 70:30 equity bond allocation rather than the usual 60:40 in recognition that Equity market neutral performance has volatility more in keeping with bonds than equities. Increasing allocations to equity market neutral moves the risk profile of the 70:30 portfolio towards that of the 60:40 benchmark. Efficient frontier shifts are robust to using a 60:40 allocation with returns and risk both being lower.

5 Expected return and risk estimates are calculated using monthly total returns over the full sample period of January 1995 to December 2018.

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