If You Build It, Will They Come?
By: Joseph Shier
Pension funds here in Canada are still far from rushing to embrace the market neutral world. Are they right to be sceptical? What place could, or should, market neutral strategies have within their portfolios? Before trying to answer these questions, I am going to describe what goes into creating a fund of market neutral strategies. Perhaps that discussion will suggest answers.
The term ‘market neutral’ can be used in different ways. At its most general, it can refer to any investment strategy with little positive correlation with equity or bond markets. ‘Market neutral’ can also have a much more restricted meaning and refer only to strategies that, in addition to lacking correlation to equities and bonds, derive their returns from mispricings or arbitrage or, more broadly, from factors not driven by general market movements. This kind of strategy can, for example, exclude strategies using instruments without a liquid secondary market such as receivables financings and life settlements. A manager can search out strategies that limit exposure to market blow-ups. Many fund of funds have these exposures, but seek to control risk at the portfolio level.
Diversified By Strategy
Even with these restrictions, a portfolio of market neutral strategies can be quite diversified by strategy, by market, by geographic region, and by risk. Returns themselves might come from:
- short-term mean reversion
- events or special situations
- knowledge advantage
- analytical advantage
- access advantage
- structural inefficiency
- provision of liquidity
- odd-lot discounts
- execution edge
- carry trades
A significant amount of the time spent on due diligence should be to identify the source of return for the strategy and the factors the manager believes will allow that return to persist. The source of return can be considered ‘alpha,’ although arguably it is a different ‘alpha’ than active long or short managers try to deliver.
The strategies included in a market neutral portfolio would then be further limited by studying down-side risks and the possible effect of forced selling because of leverage levels or financing terms. Ideally the portfolio would demonstrate a ‘volatility smile’ in the face of stress conditions – that is, increasing returns when spikes in market conditions occur, whether those spikes are up or down.
As an example, a market neutral portfolio with a zero beta target may include:
- equity markets
- interest rates
- yield curve slope
- credit and high-yield
- U.S. mortgage prepayments
In overseeing a market neutral portfolio, a manager will set an overall limit to VaR (value at risk). A manager should look, as well, at CVaR, the conditional value at risk sometimes referred to as expected tail loss (ETL). CVaR includes more extreme events – the ‘tails’ – which recognize that returns of these strategies are not distributed normally. If there is a large difference between VaR and CVaR, the implication is that there is hidden risk lying in wait.
What would the profile of such a fund be? I’ve already described the beta as being near zero. In addition, the standard deviation of such a fund would be far lower than either equities or bonds.
But investments are not made only to reduce risk, they must also provide a return. Here at Maple we have found that a diversified portfolio of market neutral strategies has consistently earned a return above tbills, though this has varied both with interest rates and with general market volatility.
Low volatility provides a big advantage to investors who are required to withdraw capital regularly. High volatility, on the other hand, helps the investor that can keep adding capital, in effect dollar-cost averaging and taking advantage of upward swings. The investor that not only needs to fund obligations, but keep up with inflation, will suffer further deterioration.
Now where does this leave pension funds?
Direct Allocation Or Overlay
A direct allocation to market neutral strategies is one way to gain exposure to this investment approach.
But there is another way. Portfolio theory calls on managers to look for assets that provide diversification and improve the efficient frontier by either improving return or reducing volatility. Each efficient frontier will have one point with the best riskreturn profile. Moving further out on the curve to generate the higher returns needed to meet a pension fund’s return assumptions means taking on more and more risk for each dollar of return.
But there is a more efficient way to generate the returns needed. By combining the most efficient portfolio with the borrowing rate available to the investor, the investor will earn greater returns for each dollar of risk than by remaining on the efficient frontier.
Overlay structures allow pension funds to use the borrowing rate in this way without taking on debt. Overlays allow the portfolio manager to focus on creating better, more efficient portfolios and then, by adjusting the level of overlay, to take the risk appropriate for the fund. Market neutral strategies which have delivered absolute returns across market cycles are, therefore, particularly appropriate to be overlaid on the existing bond and equity exposures within the pension fund’s investment portfolio. The result should be greater returns with reduced risk.
Pension funds are conservative, or so pension funds would like to believe. Perhaps they are right, although it might depend on what you mean by conservative – careful and risk-averse, or just clinging to the past and averse to change. If avoiding concentration and searching for non-correlation are the hallmarks of a conservative investment approach, it is surprising that so many Canadian pension funds limit themselves to only two asset classes – publiclytraded equities and bonds. To make those who invest in them comfortable, we call these ‘traditional’ asset classes and everything else ‘alternative,’ suggesting that the ‘traditional’ are tried and tested and, therefore, safer and the ‘alternative’ newer and riskier.
All investors seek to improve returns, and they try to do this without taking on too much risk. Investors have begun to recognize that ‘beta,’ the returns generated by the general movement of the market in which a position is held, can be isolated from the ‘alpha’ earned by an exceptional investor in that market. Yet market theory doubts that active managers can consistently outperform the public markets. Market neutral strategies give the investor the opportunity to earn a different type of ‘alpha’, that is, ‘alpha’ that does not depend on exceptionalism, but on immersion in the trading characteristics of various markets. This type of ‘alpha’ has less risk and more persistence and, I suggest, is appropriately described as conservative. As such, it would appear to fit well with the investment goals, risk tolerance, and temperament of pension funds.
Joseph Shier is managing director, Maple Financial Alternative Investments, at Maple Financial Group Inc..
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