Whether traditional long-only active fund managers can generate consistent alpha is a question that is hotly debated.
While investors increasingly seek out low cost index style options, you can expect to hear more about active extension, or long/short managers, as investors search for strategies that maximise returns in the current volatile market environment.
Since the financial crisis of 2008, global central banks, and the US Federal Reserve in particular, have been pumping liquidity into markets. This has progressively swamped volatility and driven a fantastic bull market in most asset classes. However, this policy of quantitative easing has now ended in the US and we are starting to see the re-emergence of volatility. After spending most of the year bumping along at close to historical lows, the CBOE VIX Index — a measure of expected volatility on the S&P500 Index over the next 30 days – jumped to over 30 in mid October and just four days later was down to levels approaching 16. It was lower again, at just below 15, at the time of writing. After years of stagnating, market volatility would appear to be back.
It is in this environment that long/short equity funds often come into their own.
Commenting on its Australian Shares Long/Short Sector Review earlier this year, research house Zenith Investment Partners said that active extension – or long/short – funds thrive in the current environment.
As part of the sector review, Zenith said it undertook a detailed analysis comparing the performance of Australian equity long/short funds with their long-only flagship equivalents to quantify if long/short investors are being compensated for the additional risks assumed.
Zenith concluded that Australian equity long/short funds had delivered higher returns on a net of fees basis, with slightly higher volatility (as measured by standard deviation) compared to their long-only equivalents.
Interestingly, it found the level of excess returns generated as a proportion of active share was less for long/short funds.
Zenith surmised the reason for this outcome was one of either: managers having less skill in identifying short stocks; or the market environment being less conducive for generating alpha on the short side. It concluded that given the market environment over the last 12 months, the latter was the more likely.
Benefits of a long/short investment style
It is no secret that the Australian share market is small by global standards and is dominated by a small number of very large companies.
When using a benchmark for constructing an investment portfolio, such as the S&P/ASX 200 Accumulation Index, the performance of a traditional equity fund – which only takes long positions – will be determined by the size of the fund’s shareholding of these very large companies relative to that company’s weighting within the benchmark.
By contrast, a fund that adopts a long/short strategy is also able to take a short position by borrowing the same securities from other holders and selling on market, and reinvesting the proceeds in other long positions. The idea is that this provides the long/short fund with a larger set of investment opportunities and gives more opportunity to outperform the fund benchmark.
A fund’s ability to short the securities means it is able to profit during a market downturn, and so offer a different return profile to that of typical long-only Australian equity funds.
Funds which adopt this approach are potentially able to achieve higher levels of divergence in the performance of the portfolio, relative to the performance of the fund benchmark, than can be achieved for funds which only take long positions.
But adopting a long/short strategy is only one step in alpha generation. The fund manager’s style of investing is the other. While many in the industry engage in a style debate over whether a fundamental investment strategy or a quantitative investment strategy is best approach, another option is to incorporate both.
The idea is that this strategy will generate concentrated and uncorrelated alpha from fundamental investing; and then improve on alpha derived from the breadth of the quantitative process.
Style blending
The reason for blending the two styles is simple: both approaches have their strengths and when combined provide a compelling picture.
The strength of quantitative investing is the breadth of information that captures and enables a transparent and objective assessment of a company’s relative prospects.
The advantage of the fundamental approach is the level of detail that can be gathered on a particular company and the level of investment insight that can be obtained from a detailed knowledge of a company’s operations.
The quantitative process
The quantitative process in funds management is designed to exploit particular behavioural biases that are exhibited by investors and can be explicitly measured through precisely defined factors. These factors generally fall into the categories of value, momentum or quality which enables the construction of a broad style neutral process.
The benefit of this type of quantitative process is that it enables a large number of stocks to be compared quickly and efficiently in an unbiased fashion. It provides an enormous amount of breadth to the investment process and enables a company’s likely outperformance to be assessed in an objective manner.
The fundamental process
The advantage of the fundamental process is that a significant amount of detail on a company can be unearthed and used to generate insights into its future prospects and likely investment returns.
The process involves a team of highly qualified and experienced investment analysts who conduct specialised research in various sectors of the equity market, and who seek out information not reflected in market pricing thereby identifying superior investment opportunities.
Fundamental managers use their detailed knowledge of these sectors to construct robust financial models that can be used to identify companies with superior investment prospects.
The majority of alpha generating opportunities arise from a fund manager’s ability to identify earnings changes ahead of the market that have not been anticipated in share prices.
By employing fundamental research to generate an information advantage, and overlaying this with a quantitative process to exploit the behavioural biases of the market a manager can more accurately identify these opportunities.
When taken individually, the idea of adopting one of these two processes is not groundbreaking. However blending the two into the fund management process is.
Of course, most fundamental managers do use quantitative processes as a screening mechanism, but few have incorporated it into the actual investment process. By doing so, this approach should reduce the weaknesses of both approaches while also amplifying their strengths.
By combining the two styles, it is possible to develop an approach that fuses quantitative and fundamental investment philosophies. In the case of active extension, this allows the manager to take advantage of the breadth of opportunity available from a long/short investment style while harnessing the benefits of high conviction research.
With the adoption of the unconstrained active extension management style, and the addition of a blended quantitative / fundamental investment process, a manager can aim to outperform the S&P/ASX 200 Accumulation Index by 5 per cent p.a. to 6 per cent p.a. over rolling three-year periods with a tracking error in the range of four per cent per annum to five per cent per annum.
The blended process incorporates the best qualities of the two processes into a single strategy, that is the breadth of research afforded by the quantitative process, enabling the widest opportunity set to be assessed in an unbiased fashion, while still resulting in the highest conviction portfolio due to the company specific insight gained through fundamental research.
Sean Fenton is portfolio manager of the Grant Samuel Tribeca Alpha Plus Fund.
