The market neutral strategy followed by the BNY Absolute Return Equity Fund team has a history of beating cash returns by following a pair trade approach to minimise net and beta. The fund had been managed by the team since 2005 and has a Gold N7 rating from Standard and Poor's Fund Services. The Absolute Return Equity product launched in 2011 was designed to up the ante by using the same ideas, but allowing for larger position sizes and moderate amounts of directional exposure – achieved through varying the size of the hedges. The target return for this fund is cash +6-8% per year, with alpha generation the core return driver. Over the past year, for instance, the fund’s net long equity exposure has ranged from 0% to 12% and has consequently captured a little bit of beta through positive market performance.
The investment team of Iain Brown, Richard Howarth, David Headland, Mathew Cooke, Russell Wright and head of specialist equities Andy Cawker are exclusively devoted to running the £930m AUM across the two funds and have no long-only fund responsibilities. Each manager takes ownership of up to 15 ‘pair’ trades. The managers do not have to agree; indeed, their different perspectives and sector specialities add diversification to the fund. These trades always begin with a lead stock idea, which may be long or short, with some form of hedge in the opposite direction. For example the team are currently long British American Tobacco which is offset by a short position in Imperial Tobacco. Hedges can also be baskets of stocks, sectors, or indices and any combinations of the above can appear on either side of a theme. A stock such as moneysupermarket, which has been in the fund since the beginning of 2011, has at various times been hedged against the media sector, individual financial stocks and the FTSE mid-cap. Thinking laterally, hedges do not have to come from the same sector: a short Tesco was paired against a long Astra Zeneca, as they had historically high correlations.
Returns have come mainly from stock views. Each ‘pair’ trade has a 0.40% stop loss, which means that volatility, as well as liquidity and conviction are key determinants of position sizing. This leads to a natural flexing of the gross invested amounts, which had steadily increased to just over 180% by late 2012 as market volatilities, and correlations between stocks declined.
In a world of limited GDP growth, investors place a premium on companies that can generate secular earnings growth. At the same time, the search for certainty has unduly inflated valuations of some expensive defensives. Short opportunities within the food retail sector were identified by the team when they accurately anticipated that declining real incomes in the UK would restrict growth opportunities at supermarkets such as Morrisons and Sainsbury's. The fund has been both net long and net short of most industry sectors at various times over the last few years, as the RoRo (Risk On, Risk Off) market climate has rewarded a flexible mindset.
Net sector exposures are expected to vary in a range of +/-10% and cannot exceed 20%. The Value at Risk limit is 10% but the fund is very unlikely to get anywhere close to this unless it makes full use of its potential directional stance. Net exposure can go as low as 25% short or as high as 75% long, but in practice directionality is very unlikely to surpass 30% long or 10% short. Volatility of the fund has been running at 1.8% but could go higher when and if the team decide to relax some of the hedges within the ‘pairs’. A team of risk specialists uses both in house sensitivity tools, and systems such as Barra-style analytics and style research to pinpoint the key factor exposures in the fund.
Going forward, the team seems cautiously optimistic. The fund started 2013 strongly with returns of 2.36% in January. The managers realise that a revival of the Euro crisis could rattle markets. By late February they expected there could be some pick up in volatility so had scaled back gross exposure to under 160%. Their flexible trading style means that all of the variables – stocks, sectors, gross and net – can be utilised to generate the target return.