“A lot of funds have tried to clone offshore strategies and put them into the UCITS space,” says Nayar. “I think the truth is that returns have disappointed in the UCITS space, especially compared to the offshore strategies.”
Impending regulatory change through the AIFM Directive may throw up question marks over the structure of off shore funds. In turn, it could be that European investors will need to access strategies increasingly through a regulated UCITS structure.
ARF is designed as a market neutral, beta neutral fund with a low correlation to the market – it has registered correlation of -0.06 since inception in May 2010. The fund invests in 80-100 developed European equities across a universe of 500 companies located in the Eurozone, UK, Switzerland and Scandinavia. It targets 8-10% annual returns based on approximately 6-8% volatility with daily liquidity. The fund has historically provided down side protection compared with major market benchmarks. (See Fig. 1).
Whereas the offshore fund is more eclectic in its selection of securities and trades, the UCITS fund uses a strict systematic scoring process. It is still fundamental in focus and looks at individual stocks, but looks to normalise the whole investment universe and then rank it quantitatively.
“To be able to compare cross-border and cross sector, we do all of the work in restating financials to make them comparable,” says Nayar. “We then are systematic about ranking: we have a portfolio of attractive longs and one of attractive shorts.”
The portfolio construction is engineered to be market neutral across the group of stocks. The result is that volatility is higher with the UCITS (around 5-8%) than with the offshore fund (around 2%).
With an expected Sharpe ratio of around 1.0, volatility of around 7-8% is needed to generate the desired returns. He notes that restrictions in the UCITS fund come down to the calculation of Value at Risk and how leverage affects it.
“Very clearly with this particular fund we are targeting interesting returns,” says Nayar. “The very tight volatility control of the offshore fund isn’t appropriate for the UCITS.”
The investment process is straight forward: to find quality and value in individual stock picks. The fundamental analysis looks at hard financial information for all the companies in the universe, poring over a company’s results data and analysing its balance sheet.
“The key is to focus on what is the true profitability of the firm,” says Nayar. “We are looking for the quality companies generating great returns. It means our long candidates will come from these high quality, highly profitable, companies.”
The benefits of this approach can be seen during times of market panic. In August 2011 (See Fig. 1), for example, equities fell amid sudden, wide spread risk aversion. However, the ARF actually recorded strong performance.
“When the markets hit a bump, like in August 2011, and there is an increase in risk aversion, investors go to those quality companies,” says Nayar.
“We always have a structural way of delivering returns in those highly volatile periods. A lot of these companies have a low beta. That is why our performance in August was fantastic.”
Though the fund targets quality and profitability, it also seeks value in the timing of opening a position. With the investment process filtering stocks into deciles (based on annual profitability since 2003), the top group of profit makers are tracked so that the portfolio managers can acquire the stocks when they are cheap.
Risk management process
The risk management process calls for gross exposure to be pared by one quarter if the fund falls by one standard deviation. Additionally, if a drawdown reverses, then the exposure would be dialled back up.
“We have been performing very well in periods of extreme volatility,” says Nayar. “With the net we are trying to be beta neutral. If I am long a lower beta stock and short a higher beta stock I’ll be net long. I will need to increase the size of this to hedge my beta. Net is absolutely a function of beta hedging in my portfolio. The gross exposure is how I view my risk appetite.”
As a sophisticated UCITS, the fund is governed by a VaR guideline rather than a nominal number. As the fund has been well below the VaR limit, maximum exposure has gone up to 300%, but in May was around 250% gross. The gross management system is to protect investors if the fund is under performing: if the performance is weak the gross can be decreased.
“We are very clear that we will be in high quality names,” says Nayar. “During market turbulence we are going to be in a good place. The whole process is designed to deliver good returns, but also have a characteristic that delivers good uncorrelated returns when other assets are not doing so well.”