Continued performance of equity market neutral strategy expected in 2009

While many hedge fund strategies are struggling, equity market neutral supporters believe this strategy is capable of not just protecting but also increasing capital in any market. Hedge Funds Review discusses the strategy.

Equity market neutral is one of only a handful of hedge fund strategies to have produced positive returns for investors during the financial crisis.

These funds use long and short positions to exploit inefficiencies in the global equity markets. The aim is to manage assets in a way that is neutral to risk factors in the major markets and sectors. It is a non-directional strategy and managers aim to operate with a net market exposure of close to zero.

The term can encompass statistical arbitrage strategies and stock selection strategies that are either statistical or discretionary. Sometimes the term 'zero beta strategy' is used to describe equity market neutral funds.

The lack of market exposure and the ability to profit from short positions are desirable characteristics for investors at a time when equity markets continue to trend downwards. Equity market neutral strategies are viewed by many hedge funds in their purest form, offering uncorrelated absolute returns in both bear and bull markets.

Gregor Gawron, manager of the RMF Market Neutral Strategies at RMF Hedge Fund Research, says equity market neutral was well positioned coming into 2008 because many funds had been forced to deleverage following the quant meltdown in August 2007. Many of the weaker managers were forced to close their funds at this time.

"The strategy was already sufficiently deleveraged when we entered the liquidity crisis in 2008. The fact that equity market neutral strategies are typically exposed to liquid equity markets is another reason why they performed well. It allowed managers to cope with the market turbulence," explains Gawron.

Statistical arbitrage, usually considered to be a sub-strategy of equity market neutral, is short-term orientated and traditionally performs well during periods of high market volatility. This also explains why indices show strong returns for equity market neutral strategies, Gawron adds.

Fabrice Cuchet, global head of alternative investments at Dexia, says equity market neutral strategies proved themselves to be uncorrelated to the broader markets in 2008 and served as a useful diversifier in investment portfolios.

"These strategies benefit from some volatility dispersion. The market environment in 2008 definitely helped managers to identify pair trades and relative value trades, because not all stocks were going in the same direction. An experienced stock picker using a market neutral strategy can extract good performance from relative value trades," adds Cuchet.

Not all equity market neutral strategies finished 2008 in the black. TFS Capital manages over $500 million in assets in equity market strategies across two hedge funds and a mutual fund product. Its main equity market neutral strategy was down 7.29% in 2008.

Larry Eiben, chief operating officer and portfolio manager for TFS Capital, says the mass liquidation in the hedge fund sector hurt some market neutral managers, including TFS Capital, because it caused short positions to run in the wrong direction.

"There were occasions when our long and short positions ran against us. That is only possible in a scenario where hedge funds with positions that overlapped with ours are selling indiscriminately, closing both long and short positions and causing both to run in the wrong direction. I think the outflow of capital from the long/short hedge funds explains the negative performance of some market neutral funds last year," he explains.

He believes the deleveraging cycle is largely behind the industry and expects performance to pick up in the coming months as investors go back into the market.

"There may be a few more shocks as hedge funds seek to get a grip on their liquidity, but I think most hedge funds have a good sense of the capital they have to work with and they are putting it back to work," Eiben says.

Eiben believes equity market neutral managers will do well in 2009 because many tend to be quantitative with a bias towards investing in companies with good earnings and cash flow. TFS Capital is currently fully invested and is aiming for a positive return of 7%-10% in 2009.

Move towards value
"The world is moving towards a value bias and companies that produce cash are going to attract the most attention. Market neutral funds tend to have that bias and will do well," Eiben adds.

RMF's Gregor Gawron believes the outlook for equity market neutral strategies in 2009 is neutral to positive. He says fundamentals-orientated mangers are still struggling as the market is driven by recessionary expectations making it difficult to exploit valuation inefficiencies.

"Once market participants agree on the size of the economic crisis it will be easier to discriminate between good and bad stocks. On the other side current macroeconomic uncertainties lead us to believe that market volatility will remain at high levels creating a continuous favourable environment for short-term traders. Finally, the strategy is liquid with low leverage which helps protect against huge negative surprises," he says.

Dexia's Cuchet agrees with Gawron's analysis. He thinks the market will remain volatile with an uncertain outlook and high dispersion. For Cuchet this is a situation that may bear fruit for equity market neutral managers.

"Dispersion equates with opportunities for market neutral strategies. This is likely to be a good environment for a market neutral fund. However, no one is completely sure where the market is headed, so it is very difficult to predict. But I think the strategy should perform positively and the current environment is good," adds Cuchet.

Despite their steady performance in 2008, market neutral strategies have faced criticism from some quarters. Detractors argue that equity market neutral strategies have a narrow focus and only invest in certain sectors and geographies.

Reza Vishkai, head of alternatives and manager of the Absolute Insight Fund of Hedge Funds, thinks otherwise. He says by selecting a narrow universe, equity market neutral funds are in a better position to take advantage of the skill set of their manager or analyst. Typically, fund managers perform better when their universe is constrained, he says.

"These strategies are market neutral, which means the manager is looking at the relative performance of securities. Frankly, it doesn't matter if you are geographic or sector specific," says Vishkai.

"With sector-specific equity market neutral funds, there is a greater chance of stocks moving relative to one another than if you are dealing with stocks in two different industries. It is all about creating a series of portfolios and relative bets. It shouldn't matter that they are in the same sector. If your skill is in a specific sector then you are better off sticking to what you know," he adds.

Dexia's Cuchet believes the strategy is at a disadvantage in bull markets. When volatility and dispersion are low, it can be difficult for equity market neutral funds to outperform benchmark indices.

"Because these managers are looking to capture inefficiencies between stocks, it doesn't help when the correlation between equity markets is high. These funds still create positive returns in bullish markets, although they might be in the low single digits. A volatile market is better suited to equity market neutral strategies," Cuchet explains.

In a strong bull market equity market neutral strategies are likely to underperform the average hedge fund and the broad equity indices. A manager would have to employ phenomenal stock selection to keep up with the long-only indices and strategies that take a net long position.

Bull market challenge
"The main challenge for equity market neutral strategies is keeping up with a strong bull market. From an investor's perspective, equity market neutral strategies can appear very dull with low risk-and-return profiles during bull runs. They have a tendency to be neglected in those types of markets," elaborates Nigel Kennet, a portfolio manager at Gartmore.

For investors, the main appeal of equity market neutral strategies would appear to stem from their ability to remain uncorrelated with the broader market. "Most investors add alternatives to their portfolios to complement their existing long-only investments. In this sense market neutral strategies cater to what many investors are looking for when they go into alternatives," says TFS Capital's Eiben.

This lack of correlation with the major asset classes came to the fore in 2008. For example, the HFRI Equity Market Neutral Index was down 5.98% in 2008 compared with a loss of over 18% in the broad hedge fund index.

Eiben also points out that long/short hedge funds in particular were shown to be more long than short and exhibited a higher degree of correlation to the market than many investors had expected.

It remains to be seen whether this will be enough to convince investors to commit capital to equity market neutral funds. Absolute Insight's Vishkai says all hedge funds will struggle to attract investors. But he believes there will be opportunities to raise money within regulated funds such as Ucits structures.

Under the Ucits umbrella there are a number of providers who have set up regulated equity market neutral strategies, with daily liquidity and full transparency. These structures Vishkai believes will see an increase in investor interest.

"This shake-up in the regulation has been no bad thing for Absolute Insight because this is where our equity market neutral funds have been positioned. People have been hit pretty hard by the performance of the hedge fund universe in general, and by the lack of liquidity with hedge funds putting up gates. In Ucits none of these problems exists. So hedge funds are now thinking about how to restructure products, which will make them more regulated, more transparent and more reasonable in terms of fee structures," says Vishkai.

Vishkai believes a regulated equity market neutral strategy is the best structure to put before investors at present because a skilful market neutral manager is at the very least going to protect capital even if markets continue to go down.

"Because dispersion has been high, we expect our market neutral funds to continue to perform well. However, at the end of the day it is a strategy that is all based on skill, whether you have a quantitative approach or you have a fundamental approach. It is difficult to say whether now is a good time for this strategy or not as it is completely down to the manager or the algorithm," adds Vishkai.

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