18/03/2010 Author: Tony Griffiths

The view from the top

One year on from the global recession’s nadir and the subsequent rally in the equity markets is beginning to flatten out, with some analysts even predicting the approach of a second slump. For long/short equity funds, however, an important shift in market fundamentals has take place, placing managers in a new trading environment, one which, for the first time in 12 months, will make equity-based outperformance a well-earned commodity

It’s been just over a year since the equity markets began their current rally. On the 9 March 2009, the Dow Jones, Nasdaq and FTSE 100 indices all bottomed out, before beginning a prolonged, yet volatile, climb up from the valley floor. Twelve months of heartening outperformance have followed and expectations for long/short equity funds – innately flexible, supremely liquid and, as a result, enduringly popular – remain high.    

“Equity-hedge managers will be in a good position in 2010 as the wide dispersion regarding the global recovery favours the approach utilised by many long/short funds,” said Thomas Della Casa in Man Group’s most recent annual preview. HFMWeek readers are also backing the equity-hedge space. In a February poll, long/short equity was voted one of 2010’s likely top-performing strategies – second only to global macro.

Up nearly 25% during 2009, Hedge Fund Research’s (HFR) equity hedge index outperformed the firm’s industry composite index by some margin, and commentators, analysts and managers have lined up to predict a repeat. However, though continued outperformance may be touted, this time, the message is very different – strong, equity-hedged returns are out there, but this won’t be the investment picnic managers enjoyed during the second half of 2009.  

“After the run we’d had last year, based on the market from the lows in March up until the end of the year, I was in the belief that 2010 would definitely be a stock pickers market – we weren’t going to have the type of moves or the kind of opportunities that we had last year,” says Michael Levas, CEO of Florida-based money manager Olympian Capital Management. “Essentially, in 2009 there were lifetime type-opportunities, and anytime you have a market like that, the next year is typically going to be a stock-pickers market where you’re going to have to be much more selective and dependent on what the indices are doing.”

Admittedly bullish for the year ahead, Levas is in the process of finalising Olympian’s new, US-focused global long/short equity fund, scheduled to launch in the next month. He expects to see opportunities within US financials as well as continued strong performance from the technology sector.  

Sentiment is similar on both sides of the Atlantic. Have we entered a stock-pickers environment? “I believe so,” says Luke Newman, co-manager of the Gartmore AlphaGen Octanis Fund, a FTSE 100-focused long/short vehicle. “Last year, the market didn’t reward higher-quality, better-capitalised companies in a way, I would argue, a stock picker would expect in a more rational equity environment. And when I look to this year we are starting to see signs that we are likely to get divergence in performance; we are unlikely to see all sectors moving in the same direction, and, for that matter, all companies within those sectors behaving in the same way.”

Alexander Jacobse, of Swiss-based fund manager Heieck Siebrecht Capital (HSC) Advisors, backs Newman’s stance. “If you look at the main indices, they are basically unchanged year-to-date, but if you look at the spread between the best and worst performer, it’s massive – the euro stock, for example, is about 37% year-to-date. We think there will be more increase in the diversification of company performance in this environment where you also have low growth.”   

HSC concentrates largely on German equity. Jacobse believes Germany’s export-oriented market – relative to somewhere like France – and, more significantly, its exposure to emerging markets, is likely provide a boost for German firms and the long/short equity funds that invest in them.      

“There is a growing expectation that the companies that will do well are the ones that have some sort of growth prospects through their business lines in the emerging markets,” agrees Andrew Kennedy, COO at SAM Capital. “The firms that are being more sceptically viewed are the ones that have developed-market exposure, predominantly focused on Western Europe, for example, where there is massive unemployment and debt – where is the growth going to come for that?”

Larger companies tend to operate on more mature business models and have more of an international focus, says Newman. “These are the areas that I feel are better positioned to enjoy a re-rating in share-price terms and in terms of valuation, whereas a lot of the UK-focused, more highly indebted businesses, are found further down the market cap scale,” he adds. “What this means is, if we’re right, it’s perfectly possible to see the UK market at an index level making positive headway, but, within the mix, smaller companies having tough years.”

For Kennedy, what’s interesting is that there appears to be a complete consensus on this view, and “almost always, when there’s a consensus, something isn’t going to live up to expectations,” he warns. “There is a really interesting opportunity for people that have a slightly contrarian view against all this.”

Kennedy believes that, currently, most long/short managers have a long bias – though less so than last year. The Gartmore AlphaGen Octanis Fund is a typical example. The Octanis fund moved from net negative exposure in March 2009 to net positive of between +20 and +40, reveals co-manager Newman. This changed again at the end of Q4 2009, when the fund moved into defensive companies, reducing net exposure to +10. “We’re increasingly seeing opportunities on the short side, particularly in those more cap-intensive areas of the market that have done well but we feel will be constrained in terms of their cash positions going forward this year, such as certain house builders, recruitment consultants in the UK, industrials and engineering companies,” Newman explains.   

At SAM, where the focus is more short-term than the typical manager (picks have a week-long life-span at the most), the firm’s long/short fund has been market neutral since 2009. “Both our longs and our shorts are high-conviction trades as opposed to natural hedges,” says Kennedy.

Milind Sharma, CEO of New York-based QuantZ Capital Management, is similarly cautious, advocating the market neutral status. “Investors flush from the worldwide 2009 equity rally and hoping to retire riding beta would be better served with market neutrality, given the risk of the looming correction in equities which materialised shortly thereafter,” he says. “Since the macro picture remains bleak with the risk of a double-dip coupled with the lack of meaningful regulatory reforms, we expect US equity indices to remain range bound. Markets characterised by trendless volatility correlate well with intra-sector dispersion in stock returns as factor volatility subsides, hence would be supportive of quant alpha models and stock-picking, particularly in the market-neutral context.”

Fear of a double-dip recovery is not hard to find – managers and analysts alike give the prospect credence, though not firm commitment. “Short-term overbought-risk aside, the market's uptrend should be given the benefit of the doubt over the next month or two, so long/short funds should retain a bullish tilt, however, a potentially very nasty bearish set-up may be about half complete,” warns Peter Beuttell, director of MTS Research. A technical analyst, Beuttell bases market predictions on Elliot Wave Theory – a popular concept by which market trends are linked to the same rhythmic patterns that define human behaviour.

A number of managers suggest, like Beuttell, that the current equities rally may last until the end of the first half of 2010, but all say it is too early to really tell. “The difficult thing is that nobody really knows,” admits Kennedy. “There is a tremendous tentativeness out there right now and the vast majority of managers we know and see are being very cautious and conservative in terms of their exposures to anything.”

Certainties may be in short supply, but the next few months will suit stock-pickers first and foremost, managers agree, even if market conditions are likely to reduce the times they can strike. The current environment appears well-defined, at least: conservatism is as rife as the volatility that spawned it, pushing net exposure, as a general rule, neutral to long. That said, the tools at the equity-hedge community’s disposal make long/short managers best-equipped to ride the turbulence, however long it may last, and whichever direction it takes. Come rain or shine, bear or bull, equity hedge funds have long been expected to produce absolute returns, and, in 2010, that is no different.