Fund Manager

Meet the fundie turning down the noise and dialling up the alpha

Wed 08 Mar 23, 11:01am (AEST)
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Key Points

  • Market-neutral funds aim to generate returns without the impact of the market (beta), focusing solely on the alpha component – the return that can be generated via the execution of a strategy, independent of market movements.
  • Market-neutral funds, also known as absolute return funds, offer diversification benefits by generating positive returns in all market conditions, including during periods of market decline.
  • Pairs trading is a common strategy employed by market-neutral funds, which involves going long on one stock and short on another stock in the same sector

This article was first published for Livewire Markets on Friday, 3 March.

When I first came to markets, I was a trader. I built and tested my own strategies and executed them with robot-like discipline.

I have since evolved to a longer-term investor, mainly because I don’t have the time to execute my strategy (what with a job at Livewire and two young boys), but I still love high-impact, shorter-term opportunities - and always will.

To me, such an approach offers the ability to be more precise with how I engage with the market. I can choose to be fully invested, or I can choose to be completely out of the market, depending on what my strategy is telling me at the time.

That is not a luxury that is afforded to all investors and fundies. Many mandates dictate that a portfolio needs to be 70% or 80% invested at all times, and the focus is on performing ‘through the cycle’.

I'm certainly not being critical of that type of investing (far from it), but there is something to be said about the flexibility that a more active style approach brings.

That view is shared with me by Yarra Capital Management’s Andrew Smith, who runs the Yarra Market Neutral Fund.

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Andrew Smith, Yarra Capital Management

As you will learn throughout this interview, Smith:

  • relies heavily on data to sort the signals from the noise, 

  • has a strict execution discipline, and 

  • a risk management process that gets him out of losers quickly so he can focus on the next opportunity.

He is a man after my own heart.

What is a market-neutral fund and why is it relevant in today’s market?

Before diving into the tools and tactics that Smith employs to generate alpha (and remove beta), I’ll first explain what a market-neutral fund is and why they are useful.

As the name suggests, a market-neutral fund aims to generate returns for investors without the impact of the market (the term for which is ‘beta’). For example, if the market goes up 5%, and your portfolio goes up 5% over the same period, you have simply achieved the market beta.

If the market goes up 5%, and your portfolio goes up 9% due to stock selection and active management, you have added 4% of alpha to the 5% of beta the market has given you.

There is, however, another option. You can employ a strategy that actively seeks to remove the impact of the beta, focusing solely on the alpha component – the return you can generate via the execution of your strategy, independent of what the market does.

Why on earth would you want to do that?

Good question. And there are a couple of answers.

Firstly, markets go down as well as up. In the example above, it’s all positive, but what about a year when the market falls 9%?

Imagine being able to remove that impact and instead just focus on the alpha you can generate. That’s powerful in its own right and in the context of diversification of returns in a broader portfolio.

Think about most retail investors’ portfolios. They largely do well when markets move in one direction only, i.e. up. Yes, you can get some diversification with bonds, although even that relationship has been challenged over the past couple of years, with bonds offering very little protection.

What if you could generate a positive return when the market tanks? Imagine the protection it could offer for the rest of your portfolio during a down period, to say nothing of the absolute returns being earned (market neutral funds are also known as absolute return funds – which means they aim to generate positive returns, regardless of the market conditions).

What is this sorcery you speak of?

While all of that might sound fanciful, rest assured, it is not. There are some clear, quite well-known strategies that can be employed and Smith shared some of his with me.

Pairs Trading

Smith openly shares that the majority of what he does is pairs trading. But what is pairs trading and how does it eliminate market risk?

“It means we might go long BHP and short RIO. Two stocks, same GICS sector, same macro factors. So we're not worried about what GDP growth is doing, what US interest rates are doing, or currencies because they both are affected by the same drivers”.

“Instead, we are looking at what will move those different securities. It's very much idiosyncratic risk, it's about the stocks. We look at correlation and cointegration. Those things sound complicated, but they're not. Correlation means you go together, cointegration means you go together and mean revert”.

Like all good traders, Smith loves data. He has examined 1200 pairs in Australia to find the best, most profitable opportunities he can continually take advantage of. From that 1200 came a universe of around 120 pairs worth trading.

At any one time, Smith will have up to 25 trades open. The pairs trading strategy is not built like a long-only equities strategy that might have a 30% turnover in a year, however.

This one's a bit more punchy and it's got 300% turnover and I can take much bigger high-conviction positions. I can have a 10% long, 10% short. That's massive. Especially in a long-only world where they might take a 2% or 3% position. It's high conviction, higher turnover, systematic, repeatable, proven process that's founded on a lot of academic research.

To trigger a pairs trading opportunity, the spread between the prices of the two stocks must be two standard deviations above or below the spread mean over a specific period. The two standard deviations ensure that the spread if significant, relatively rare, and has a high probability of reverting to the mean (for the statistically minded, we’re talking a 95% confidence interval).

Just because the spread reaches two standard deviations, however, that does not automatically mean there is a trade, far from it in fact. The signal is merely an opportunity to investigate further.

Illustrating the point above with the BHP Group (ASX: BHP) and Rio Tinto (ASX: RIO) example, Smith notes that a while back they were “trading along nicely together as you'd expect. And then RIO had the incident where they damaged the sacred Aboriginal site, and the stock fell about 10% in two days”.

That saw the correlation between BHP’s and RIO’s share price change dramatically, triggering an opportunity to take advantage of the movement in RIO.

As Smith explains it, “I'm looking for structural or cyclical changes. A structural change is when you get a new CEO and they are terrible, or a company makes a bad acquisition. It's more long-term. A cyclical, or short-term issue generally has a relatively short-term impact on the share price”.

Ultimately, it created a deviation in the share prices of the two stocks, which would mean a revert (cointegrate) over time. In this instance, the opportunity was to buy RIO at the depressed price and sell BHP, hence removing the market risk but providing the opportunity to take advantage of the recovery in the RIO share price – which is ultimately what happened.

Another way to think about eliminating the market risk is in terms of dollars exposed to the market. “If an investor gives us $100, we will go and buy $100 worth of stocks and we'll also short sell $100 worth of stocks. By doing that, we have no market exposure.

That's what market neutral means. The $100 provided by the investor actually goes back into the bank, and there is no market exposure. “The way we generate returns is what happens between the two stocks”, adds Smith.

Like any strategy, pairs trading has both benefits and drawbacks. As Smith puts it, “if the US is down 50% tonight, our fund is not going to be. Conversely, if the market's up 50% tonight, we are not going to be either. It does go both ways. But this style of fund is about capital preservation, uncorrelated returns, and lower volatility with equity-like returns”.

The other benefit that Smith highlights (and which is common to most successful traders) is that the pairs trading strategy allows him to turn down the market noise, and focus on the opportunities that will deliver alpha.

There's all sorts of information which you can loosely call noise. I had to figure out a way, how the heck can I cover the whole Australian market in a systematic, proven, repeatable way and get rid of all that noise.

Certainty creates flexibility

One of the key components of the Yarra Market Neutral Fund is the flexibility that the strategy offers. That flexibility is borne partly out of the speed of execution, and the way risk is managed.

As Smith points out, “one obstacle that fund managers have is the latency of decision making”. Working with the RIO example above, he notes that after an event occurs, the conversation between an analyst and a portfolio manager might take some time, from days to weeks. For Smith, the decision-making process is much quicker.

My framework identifies the mispricing when it happens. So I'm quite fast at making this decision. And that's what I mean by flexibility.

Smith also has a very tight risk management system that utilises stop losses to kill positions that are not moving as planned. This allows Smith to cut his losses and move onto the next opportunity.

This is something that's more of a nuance and I'm not sure how many people would say this to you, but a problematic position in the portfolio takes a lot of mental capacity.

Both of these strategy elements, speed of execution and strict risk management - and their strict application - provide certainty, which in turn provides the flexibility needed to consider new opportunities.

Other alpha generators

While we have talked a lot about pairs trading, Smith also participates in IPOs and placements, as well as statistical arbitrage on M&A activity, which he explains as “a fancy way of saying generally you go long the target and short the acquirer”.

As for placements, Smith has a tried and tested methodology that involves “a checklist of seven or eight things that I look at”. 

Smith was quite guarded with the elements of the checklist – and fair enough. I know quite a few fundies who trade placements and they are all pretty cagey regarding the secret herbs and spices.

He did, however, give up that one of the elements is the size of the raise as a percentage of the total market cap. 

So generally, if it's large, it will be soggy in the aftermarket. But I have another five or six things I also look at.

WHAT IS THE BENEFIT FOR INVESTORS?

I could have talked about strategies, risk management, and trade execution all day with Smith. He is a fascinating person to talk to if you’re that way inclined. But I had a job to do for you, the Livewire readers, and that was to press Smith about the benefits for investors of a market-neutral strategy.

Smith posits that there are two aspects to the answer.

“One is we've had 10 years of synchronised central bank collusion, which is a strong word, but I think it's relevant by forcing interest rates down." 

That has meant that any asset, be that a classic car, stamps, coins, shares, houses, wine, any bloody thing that's called an asset has gone up in value. The degree of difficulty was almost zero. So that's like a free kick for beta (beta being market return).

Smith adds that one of the reasons why index funds have had a relatively easy run over the past decade is because of this free beta. But that is all changing now.

The interest rate cycle has changed, inflation is prevalent and may or may not be controlled quickly. We don't know the answer. But what I think we do know is that active management will be more important.

As for market neutrality, Smith notes such a strategy does two key things. “It's got a capital preservation component, but it also has multiple alpha sources.

“We have four alpha sources. I feel that this style of product can generate alpha or excess return through the cycle”.

Finally, Smith acknowledges that he is often asked, “Andrew, when should we be going back to market neutral? When do we need the protection?”

His answer is that it's not really the right question. The right question is, “what weighting should we have now?"

So, what weighting should you have now?

Written By

Chris Conway

Managing Editor

Chris is the Managing Editor at Livewire Markets and Market Index. His passion is equity research, portfolio construction, and investment education. He is also very keen on the powerful processes that can help all investors identify great opportunities and outperform the market, and wants to bring them to life and share them with you.

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