Hedges on Hedge Funds Chapter 9 docx

CHAPTER 9 CHAPTER 9 The Time Is Now for Equity Market Neutral A s is the case with convertible arbitrage and fixed-income hedge fund investing, equity market neutral is characterized as a relative value strategy. However, it is not pure arbitrage; this strategy generally trades on the differences in value across a wider range of less closely related securities, which is not the case in convertible arbitrage and fixed-income arbitrage. Equity market-neutral managers construct portfolios that have close to equal amounts of offsetting long and short equity positions. By bal- ancing long and short positions, market-neutral managers attempt to mitigate events that affect the valuation of the stock market as a whole, which implies very low or no correlation to the market. Investors in equity market neutral strive to generate consistent returns in both up and down markets. To determine the right time to start ramping up the market-neutral allocation to one’s investment portfolio, it is first necessary to understand what has been holding this strategy back as compared to other strate- gies. Examination of recent past performance might help determine when these adverse conditions have been alleviated. Investor sentiment points to the lack of market volatility as the culprit, yet this is not en- tirely accurate. Although volatility is indeed vital to the success of many market-neutral strategies, statistics support the fact that volatility is not the sole issue with which to be concerned. The popular VIX, Chicago 133 c09_hedges.qxd 8/30/04 12:10 PM Page 133 Board Options Exchange volatility index, which measures implied vola- tility, has been registering a comfortable mid-20s reading since 1997, which is impressive considering that a register of 20 is considered healthy volatility. This average had not been seen since the Gulf War days and suggests no lack of overall market volatility. That index is, however, not perfect, because it measures end-of-day implied volatility; intraday volatility would provide a better sense of the opportunities available during the day. However, since it is the best measure available, it is worth analyzing in more detail. Consider a re- gression analysis, where the VIX Index is the independent variable and the HFR Equity Market Neutral Index over the last decade or so is the dependent variable. The correlation is around −6 percent, strongly sug- gesting that overall volatility should not be viewed as the primary driver of market-neutral returns. Clearly, however, low market volatility tends to decrease the number of alpha-generating opportunities available to equity market-neutral managers. When market volatility subsides, mar- ket efficiency tends to rise. As mentioned, equity market-neutral managers prefer those periods of volatility so that they can go after additional prof- its. (See Table 9.1.) 134 HEDGES ON HEDGE FUNDS TABLE 9.1 CBOE Volatility Index Gauges Market Volatility Year VIX 1997 24.01 1998 24.42 1999 23.40 2000 26.85 2001 23.80 2002 28.62 2003 18.31 Source: Provided courtesy of Chicago Board Options Exchange, Incorporated. The VIX Index, a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices, is considered by many to be the word’s premier barometer of investor sentiment and market volatility. c09_hedges.qxd 8/30/04 12:10 PM Page 134 The Time Is Now for Equity Market Neutral 135 Managers use a variety of methods to mitigate market influence on their funds. Some use pair trading, which involves purchasing one secu- rity and selling short a fundamental sibling using a preset ratio to elim- inate the effects of market and sector risks. For example, if an investor bought Diamond Offshore Drilling and sold short Noble Drilling Corp., he or she would be exposed to similar risks on a market and sector basis because both companies are energy drilling ones with similar assets located in similar geographic regions. The key to success relies on deter- mining which security to buy and which to sell. In essence, the process aims to isolate the security selection skill of portfolio managers or, in the case of technical managers, their ability to construct the appropriate models to capture the relative inefficiencies between securities. Talented managers can do this effectively and capture alpha from dynamics that may alter the spread between securities. Others add, or use exclusively: a beta-neutral strategy, where positions are taken based on a stock’s level of market risk; a dollar-neutral strategy, where equal dollars are invested on both the long and short sides; mean regression, where posi- tions are taken with the idea that the securities will revert to their his- torical relationships their trading relationship will hold; or numerous other combinations. No universally accepted definition of equity market neutral exists, yet an increasing commonality among funds executing this strategy is the use of complex statistical models to capture numerous market- neutralizing dynamics. These hedge funds can appear attractive because they are designed to make money regardless of market movement and thus tend to be safe havens for excess capital. Because the strategy is generally long and short similar equities, the absolute direction of the securities matters less than the relative movement of the securities. Provided the long outper- forms the short, the strategy will make money. The strategy’s return is a function of the movement of the long and short security in addition to dividends received and paid, which are added to the short sale interest. The obvious question is how the equity market-neutral strategy has performed relative to the market. The HFR Market Neutral Index, which monitors a broad representation of equity market neutral hedge c09_hedges.qxd 8/30/04 12:10 PM Page 135 136 HEDGES ON HEDGE FUNDS funds, has maintained a less than 15 percent correlation to the S&P 500, Dow Jones, Nasdaq, and the Morgan Stanley Capital International Europe, Australasia, Far East, which measures international equities. In addition, the Market Neutral Index has maintained a far superior risk- adjusted return to the broad market, as evidenced in a much greater Sharpe ratio. At the most general level, return from equity market neutral is derived from three sources: profits of both long and short positions and interest from margin deposits on the short positions. More specifically, the key factors that drive returns for this strategy include market volatil- ity, market rationality, and not-so-strong bull markets. Market volatility is important because it allows managers to benefit from information inefficiency by capitalizing on times when certain stocks may be trading away from their fundamentals, based on something not being factored in correctly or because of numerous other events. Market rationality is probably the most critical driver of profitabil- ity of equity market-neutral managers. The strategy profits when mar- ket perception and reality are aligned, specifically, in an environment where good earnings announcements and earnings growth lead to higher stock performance and, conversely, when no earnings or growth poten- tial lead to lower stock performance of companies. Therefore, to market- neutral managers, security selection is a vital component of success. Equity market neutral involves trading absolute positions for relative outperformance and, as a result, which side of the trade tends to matter more than the trade itself. As a result, if the perception/reality argument is out of line, the strategy will suffer. (See Table 9.2.) Strongly bullish markets matter in that during these times, equity market neutral will tend to underperform the market simply because TABLE 9.2 Market-Neutral Equity at a Glance Historical return 10%–12% Historical volatility Low (3%–5%) Risk characteristics Conservative Expected correlation with equity markets Low (0.1) c09_hedges.qxd 8/30/04 12:10 PM Page 136 returns are truncated by the short security component of returns. In strongly bear markets, the strategy tends to outperform the market. What is needed to swing the market-neutral pendulum into vogue is a realignment of reality and perception. This situation will occur when earnings and cash flow performance are reflected in the movements of security prices. During the past couple of years, attention has focused on the fact that implied valuation of the market was too high, and the de- bate thus was about “irrational exuberance,” the need to change valua- tion parameters in a new economy, and, more recently, the quality of earnings. These discussions focused on broad valuation issues rather than on individual security circumstances. Even now, with the market having adjusted somewhat since the Internet years, the forward price/earnings of the S&P 500 is still over 20 times next year’s earnings. This is not cheap by any stretch of the imagination, given historical standards, but is much lower than the high-flying period from late 1998 to early 2000. More critical than forward multiples, though, is the perception ver- sus reality argument. Specifically, the environment should show good earnings announcements and earnings growth to achieve higher stock per- formance. Back in the dot-com heyday, market-neutral managers found themselves laggards to their competitors because they were managing against the seemingly unreachable expectations of dot-com companies. Good news translated not only into better stock performance, but also into unjustifiable security performance. Scores of companies announced better-than-expected numbers only to see their stock plummet, while oth- ers missed their expectations and witnessed an appreciation of their security. In short, the environment was dominated by macro factors, which thus relegated individual security valuation issues to a subordi- nate role. Indeed, even though fund managers may have made the cor- rect analysis on a security relative to other comparables, losses may have resulted because the market was looking past valuations. Although this example is a simple one, it highlights how good fundamental work still can lead to bad results. Security selection risk is critical to the success of the strategy. Because of the relative return nature of the strategy, being able to choose the outperformers and underperformers is the bottom line in equity market neutral. Rational markets are vital to the strategy’s success. The strong The Time Is Now for Equity Market Neutral 137 c09_hedges.qxd 8/30/04 12:10 PM Page 137 bull market of late is characterized by investors rewarding speculative lower quality stocks making it very difficult to identify short candidates. The unusual component of this market behavior was persistence, some- thing that many market-neutral managers have not experienced in the past. (See Figure 9.1.) The year 2003 brought another problematic year for equity market- neutral managers. The HFRI Market Neutral Index posted returns of −2.38 percent, while the S&P 500 and the Nasdaq posted returns of 28.3 percent and 50.6 percent, respectively. The strong bull market adversely affected the strategy, held back by the mandated offsetting short equity positions. The end of the war in Iraq, low interest rates, favorable tax law changes, and fiscal stimulus helped create a strong rally in the equity markets that persisted throughout the year. Investors’ willingness to increase their risk tolerance helped push higher not only undervalued quality stocks, but also low-quality speculative stocks that are usually held short by market-neutral managers. Consequently, for most of the year, market-neutral managers saw the gains in their long portfolio more than offset by losses in their short portfolio. This per- sistence has happened only two other times since 1986. The rally in low- quality stocks was further aggravated by the “short squeeze” when managers trying to cover their short positions pushed prices even higher. Market-neutral managers who focused on mean regression also suf- fered from a market where opportunities for this style of trading were minimal. Reduced market volatilities persisted for most of the year, pro- viding very little mean reversion opportunities for statistical arbitrage market-neutral funds. The decline in volatilities was attributed to the very low level of dispersion among investors throughout the year as the equity market rallied. The U.S. economy grew approximately 4.4 percent in the first quar- ter of 2004. There is strong evidence that employment is improving, and despite an expected slowdown in consumer spending, capital spending is expected to take up the slack given the improvement in corporate bal- ance sheets. Some potential factors could slow growth, in particular geopolitical risks or an extended pause in consumer spending. However, despite these risks, it appears that the economic recovery will be sus- 138 HEDGES ON HEDGE FUNDS c09_hedges.qxd 8/30/04 12:10 PM Page 138 Strategy Intention Source of Profits Risk Return Profile Role in Portfolio Risk Exposure • Generate profits by taking offsetting long and short positions in related equity securities • Difference between the long and short positions • Conversion on violations of the “law of one price” • Purest form of alpha (verses equity indices) • Low beta (generates returns with negligible exposure to market as a whole) • Sustainable, smooth, positive returns • Volatility reduction • Portable alpha in fund of funds • Average year: 10.23% Worst year: 2002 0.98% • Interest rate risk: low • Equity market risk: moderate • Credit risk: low • Counterparty risk: low • Funding liquidity risk: moderate • Leverage risk: low • Operational risk: moderate Worst Case Factors: • Strongly bull markets • Low volatility markets • High intraday volatility Favorable: • Volatile markets • Information inefficiency • Rationally driven market Scenario Factors Equity market neutral is a volatility reduction strategy, with very low equity market beta. FIGURE 9.1 Equity Market-Neutral Strategy Profile. 139 c09_hedges.qxd 8/30/04 12:10 PM Page 139 Interest Rate Risk Funding Liquidity Risk Leverage Risk Grey = Plane of Risk Legend 5 = high exposure 1 = low exposure 0 = no exposure • Low interest rate risk • Low correlation to bonds • Performed well in 1994 • Low credit risk • Performs well in volatile environment • Increased with dwindling volatility • Increased in strong bull markets • Increased with high intraday volatility Operational Risk Counterparty Risk Credit Risk Equity Market Risk 0 1 2 3 4 5 The dominant risk in equity market neutral is stock- and manager-specific, both diversifiable. FIGURE 9.2 Equity Market-Neutral Risk Profile. Source : LJH Global Investments, LLC. 140 c09_hedges.qxd 8/30/04 12:10 PM Page 140 tained throughout the balance of 2004, and additional inflationary pres- sures from a falling dollar and fiscal deficits will most likely not push the Federal Reserve from its accommodating stance to tightening until later in 2004. Investors will likely see a continuation of gains in the equity mar- kets as favorable conditions accommodating fiscal and monetary policy and positive gross domestic product growth continue. Corporations look better positioned through recapitalization and reorganization; how- ever, their equities are less undervalued than in 2003. As a result, inves- tors most likely will focus more on fundamentals, such as earnings growth, than speculation. The undervaluation of the market has been mostly elim- inated, making opportunities from risky assets less prevalent. This fact should help market-neutral managers to minimize some of the losses in their short portfolio, allowing them to refocus on their analysis and secu- rity selection skills. (See Figure 9.2.) Inflationary pressures from commodity prices, a growing deficit, and falling currency will most likely push interest rates higher late into the second half of 2004, putting the brakes on equities and increasing volatility. Statistical arbitrage market-neutral managers who benefit from increased volatility should find the environment more favorable especially in the latter part of 2004. The Time Is Now for Equity Market Neutral 141 TIPS Equity market neutral is a relative value strategy that trades on the differences in value across a wider range of less closely related secu- rities. Market-neutral managers attempt to mitigate events that affect the valuation of the stock market as a whole by balancing long and short positions. Because an investment in equity market- neutral hedge funds strives to generate consistent returns in both up and down markets, it can be a wise strategy in either an up or a down market. c09_hedges.qxd 8/30/04 12:10 PM Page 141 142 HEDGES ON HEDGE FUNDS ■ Pay close attention to the popular VIX (CBOE Market Volatil- ity) Index, which measures implied volatility, and track how when market volatility subsides, market efficiency tends to rise. ■ Know that equity market-neutral managers prefer volatile mar- ket periods when they can attempt to realize additional profits. ■ Understand that other key factors that drive returns for equity market-neutral hedge funds are market rationality and not-so- strong bull markets. ■ Evaluate how equity market-neutral hedge funds mitigate mar- ket influence on their funds through pair trading, beta-neutral strategies, and so on. ■ Be cognizant that strategy returns are a function of the move- ment of the long and short securities as well as to dividends that are added to the short sale interest. ■ Monitor security selection risk, which is critical to the success of the strategy; because of the strategy’s relative return nature, being able to choose the outperformers and underperformers is the bottom line in equity market neutral. ■ Realize that strong bull markets adversely affect the equity- market-neutral strategy, which is held back by mandated offset- ting short equity positions. ■ Understand that market neutral managers who focus on mean regression suffer in a market where opportunities for this style of trading are minimal. ■ Corporations now appear well positioned through recapital- ization and reorganization, and investors are likely to focus more on fundamentals, such as earnings growth, rather than speculation. ■ Inflationary pressures from commodity prices, a growing deficit, and falling currency will most likely push interest rates higher late into the second half of 2004, putting the brakes on equities and increasing volatility. c09_hedges.qxd 8/30/04 12:10 PM Page 142 . in consumer spending. However, despite these risks, it appears that the economic recovery will be sus- 138 HEDGES ON HEDGE FUNDS c 09 _hedges. qxd 8/30/04 12:10 PM Page 138 Strategy Intention Source. PM Page 135 136 HEDGES ON HEDGE FUNDS funds, has maintained a less than 15 percent correlation to the S&P 500, Dow Jones, Nasdaq, and the Morgan Stanley Capital International Europe, Australasia,. rise. As mentioned, equity market-neutral managers prefer those periods of volatility so that they can go after additional prof- its. (See Table 9. 1.) 134 HEDGES ON HEDGE FUNDS TABLE 9. 1 CBOE Volatility