You may have heard the term “hedged hedge funds.” It’s an expression some managers use to differentiate what they do from the hedge funds that wind up in newspaper headlines.
If hedging is understood as a method of reducing risk, then most hedge funds that make the news aren’t hedged at all. Instead, they tend to employ levered, risky strategies designed to give high rollers double- and triple-digit returns. Many of these funds won’t even look at clients investing less than $1 million.
Their mislabelling is too deeply ingrained in the financial world’s consciousness. So, to describe hedge funds that are actually hedged, we speak of hedged hedge funds.
“A true, authentic hedge goes back to the principles of Alfred Jones,” says Michael Kimmel, portfolio manager at Picton Mahoney Asset Management in Toronto. Jones was the American investor credited with creating the first hedge fund in 1949. His approach catered to “wealthy people who wanted to preserve and grow their wealth in a conservative fashion,” explains Kimmel. Jones used tools such as leverage and shorting to rein in risk, rather than augment it.
Market neutral…with a twist
One approach to market neutral uses quant and fundamental analysis but adds a third dimension: event-driven strategies. James Hodgins, CIO of CHS Asset Management in Toronto, says these include:
- Merger arbitrage: In an M&A scenario, this typically involves shorting the acquiring company, and going long on the target (see “Use hedge funds to profit from M&A,” AER October 2014).
- Convertible bond arbitrage: Going long on a company’s convertible bonds, and shorting its common stock.
“At the portfolio level, we want to be neutral,” says Hodgins. The fundamental and quant components get an overlay of four risk factors:
- Beta: target within 5% of neutral
- Sector: target within 10% of neutral
- Company size: target within 20% of neutral (weighted-average market cap of longs within 20% of weighted average market cap of shorts)
- Liquidity: target within 20% of neutral (weighted-average dollar trading volume of longs within 20% of weighted-average dollar trading volume of shorts)
Hedged hedge funds come in a variety of mandates. The one that will likely appeal most to risk-averse clients is the market neutral strategy.
How it works
The purpose of the strategy is to make market direction essentially irrelevant to the fund’s performance. This is done by using both long and short positions.
A simple example illustrates the basic template. “An investor puts in $100. The first thing we do is put it in a risk-free asset like a T-bill,” says Kimmel. “Then we find a company we hate and we’ll short it for $100. We’ll then use the proceeds [of the short] to buy a stock [we like] for $100. So your net exposure [to the market] is 0%.”
Keith Leslie, portfolio manager at Norrep Investments in Calgary, uses a similar approach: but, instead of T-bills, he builds a portfolio of 15 to 20 investment-
grade bonds. The bonds are held to maturity, making what happens in the bond market irrelevant. Average duration is nearly three years and average yield is about 3%. He uses the yields to cover his fund’s expenses.
Leslie’s fund has around 50 long names and 50 short, with a target weight of about 2% per position. To maintain 0% net exposure, he rebalances daily. “I start each day by asking which positions are out by $50,000, for example. I set up a spreadsheet and my goal for the day is to trade them back to their target weights. If a long position goes up 30%, I sell some off and lock in profits to bring it back to target.”
He usually makes 30 to 40 trades a day. “With zero exposure, you have zero correlation to the market. A typical mutual fund will have 100% equity market exposure.”
Other market neutral funds can deviate slightly from 0%. “On the portfolio level, we hover around 0% net exposure, but when we’re wildly bullish we can take it up to 10% [net long]; when we’re wildly bearish we can take it down to 10% [net short],” says Kimmel. On a sector level, he allows 5% wiggle room in either direction.
Leslie notes both types of fund can have a place in client portfolios (see “Better than bonds?”).
Market neutral’s kryptonite
Being wrong about which name in a pair will do better is an obvious risk to market neutral funds.
But the big risk to this strategy is shorting a company that gets acquired.
That’s because, when companies are acquired, it’s typically at a premium, so the stock price jumps.
“You don’t want to walk into the office on a Monday and find that a company you’re short for a massive weight got taken out for an 85% premium, because you probably just blew up the fund,” says Michael Kimmel, portfolio manager at Picton Mahoney Asset Management.
“We’ve had companies taken out that we’ve been short on, but it’s never blown up the fund [because] we spread the risk of our shorts out. If I have a 3% weight in a company I’m long on, I may offset it with three individual 1% weights on the short side.”
In both cases, downside protection is a key feature, thanks to zero or near-zero correlation to the equity markets. Market neutral won’t capture all the upside when the market’s on fire, but don’t be surprised if you see no losses—or even gains—when the broader market tanks.
The core feature of many market neutral funds is pairing long and short positions within sectors.
For instance, if the manager is long Bank A, he’ll short Bank B. Importantly, Bank B’s price doesn’t have to go down: to make money, all the manager needs is for Bank A to go up more or down less than Bank B. So:
- If Bank A (long) goes up 15% and Bank B (short) goes up 10%, it’s a 5% gain on the bet.
- If Bank A goes down 11% and Bank B drops 13%, it’s a 2% gain on the bet.
- If Bank A goes up 15% and Bank B goes up 20%, it’s a 5% loss on the bet.
- If Bank A goes down 11% and Bank B drops 8%, it’s a 3% loss on the bet.
“Sixty percent of our [positions] are exact pairs, right down to the sub-sector,” says Leslie. Matching longs and shorts on as granular a level as possible—bank to bank, rail carrier to rail carrier—reduces most external risk, leaving the outcome of the trade to the manager’s company analysis skills. For instance, “If I’m long a gold stock and short a gold stock, the price of gold is partially irrelevant to me. Both go up or down based on the price of gold, but I’m predicting the better company will do better regardless of the gold price.”
The other 40% of Leslie’s pairs match on the sector level only. One example is Canadian Tire (long) and Torstar (short): they’re both consumer discretionary and should be affected by consumer spending, “but one is a retail store and one is a newspaper, so it’s not a perfect pair.”
Better than bonds?
When market neutral managers say the strategy’s conservative, they mean it.
Michael Kimmel, portfolio manager at Picton Mahoney Asset Management, describes it as a “bond alternative.”
The 30-year bull market in bonds is over, he says, “so you’re probably going to get negative returns in that part of the portfolio. That means 40% of a portfolio [using] the traditional [60%/40%] asset allocation model is broken.” Market neutral can “replace what you once would have gotten in a bond portfolio.”
The strategy can also be ideal for income investors who rely on dividends, says Keith Leslie, chief risk officer and portfolio manager at Norrep Investments. Because it’s hedged, a market neutral fund that pays a dividend (not all do) is less risky than a long-only approach to dividend payers.
Kimmel’s research team has two parts: quantitative and fundamental. And they’re not allowed to talk shop with each other.
The quant team uses a model with about 25 factors, including earnings estimate revisions, sequential earnings acceleration, free cash flow yield and free cash flow growth. The model assigns an alpha rating to the entire universe of stocks. Bi-weekly, the quant team produces an optimized portfolio of about 200 names (longs and shorts), including weights.
Down the hall, the fundamental analysts are building sector-level portfolios. “They do what good old fundamental analysts do: they’re meeting with management teams, doing proprietary research, site visits, going to conferences, talking to Wall St. people, etc.
“As the portfolio manager, my job is to find the overlaps. If one pillar of the organization is telling you something, and the other pillar, coming at it from a completely different angle, arrives at the same conclusion, I would be crazy if I didn’t buy at a bigger weight than they both suggest.”
Leslie uses a quant-based approach with a value overlay. “If you’ve heard of growth at a reasonable price, my approach is momentum at a reasonable price.”
He runs about 700 names though Morningstar CPMS, including ROE, P/E, momentum, yield and cash flows. To make his shortlist, companies have to be beating analyst expectations, getting upward analyst revisions and have quarterly earnings growth. “Then I put on the value overlay, [asking myself:] What am I willing to pay for it? The market tends to trade at 16× to 18×, so, as long as I can pay less than 16×, I’m happy. Currently, my long portfolio is trading at 13.5×.”
His fundamental team also helps with the more qualitative side of company analysis. “Before I establish my position, I’ll tell them, ‘I want to go [long] XYZ Co.,’ and [one] may come back and say, ‘You know what, I met those guys and they weren’t very strong.’ ” So he stays away.
On the short side, he’s looking for companies that are overvalued compared to the market and to what they’ve historically traded at. “I also want them to be missing analyst expectations, and shrinking. My shorts are trading at 21×” (see “Key figures on longs and shorts”).
Quant analysis is all about tendencies, says Keith Leslie, portfolio manager at Norrep Investments.
“Given this set of circumstances, this is how a company should react.” But it doesn’t always work that way. “Until this year, I’ve been about 20% energy because my energy quant screens have worked great. They stopped working in February, so I pulled my weight back from 21% to 10%. When [energy companies] start reacting the way I think they’re supposed to, I’ll creep my weight back up.”