Most equity hedge funds vary their net exposure to markets. Most of the minority that don’t are market-neutral equity funds. These funds are structurally market-neutral – they commonly have a tolerance band of plus or minus 10% net market exposure away from absolute market neutrality, but the balance sheet cannot be anything other than very-close-to-neutral. There are two ways of creating a market-neutral portfolio – from the bottom up, or using quantitative methods of stock selection and portfolio construction. More than 98% of equity market-neutral hedge fund portfolios are constructed using quantitative methods of forecasting individual stock returns, and then using optimizers in combination with a series of portfolio construction constraints. To build a market-neutral equity hedge fund using discretionary management approaches rather than systematic ones is very unusual, and to be successful requires meeting a number of particular requirements.
One firm that has met the particular requirements well is Insight Investment. The UK asset manager, part of the BNY Mellon group, has a double rare distinction – in the Absolute Insight UK Equity Market Neutral Fund it has a commercially successful UCITS-format hedge fund and, as the name partly tells, it is successful through taking a discretionary market-neutral approach.
Low risk low vol can sell
Andy Cawker, the Head of Specialist Equities at Insight, describes the fund as “a low-risk, low-volatility hedged fund rather than a hedge fund. It is a portable alpha strategy that has not had a down year or down rolling 12 months in its track record.” The fund has returned 3.1% p.a. net to investors over the last five years compared to 1.9% p.a. for 3 Month GBP Libid over the same period. The five-year return is twice the return from the FTSE-All Share Index, and the return stream produced has some attractive attributes – the correlation with the FTSE-All Share Index is a de minimis 0.04, volatility has been 1.55% since inception and the Sharpe ratio, at 1.4, is extremely high for an equity hedge fund. The whole track record is shown in Table 1.
The fund is run with two constraints to minimise the impact of market direction. The net exposure has the classic constraint of +/- 10%, and the portfolio predicted beta must not exceed +/- 0.15. The fund managers construct a portfolio with pair trades to generate the return. Hedges are chosen to isolate the risks that the portfolio managers want to take, and each pair is subject to a stop-loss trigger set at 15bps loss to the NAV. The stop-loss limits the impact of any one pair, but also enforces a mental discipline on the portfolio manager who puts the pair on. The stop-loss makes the portfolio manager recognise that the original investment hypothesis for the trade was either incorrect or ill-timed.
The presiding genius model of running a hedge fund seems to be fading. It is more usual to see asset management firms offering two investment professionals operating in tandem to run a hedge fund, and for the leaders to be backed by a coterie of analysts. Neither model is applied by Andy Cawker. He has a broad team in which there are five Absolute Return portfolio managers, of which Cawker himself is one, plus a dedicated analyst.
In the once dominant presiding genius (or name-over-the-door) model it is clear whomakes the decisions. For all the other models of investment professionals working together on a single investment strategy it can vary enormously how both key and minor decisions are made. Limited voting, casting vote, equal weighting democratic votes, both or all have to agree on all decisions, watering down any decision not agreed unanimously, and right of veto on all decisions beyond a certain level of portfolio impact are all used. And no voting at all. One way to have clear decision making authority is to carve up the capital into discrete chunks which are owned by one person. This is the method used by the Specialist Equities team at Insight. The portfolio managers in the team are Andy Cawker, Richard Howarth, Iain Brown, David Headland, and Matthew Wright, supported by absolute return analyst, Russell Wright, and a dedicated dealer Stephen Quantrell.
An intensity of focus
Andy Cawker explains, “There is a team of fund managers that run the fund, though decision making is not done on a team basis. Each of us runs a group of 10-15 stocks, which enables us to have that intensity of focus. We don’t specialise by sectors; we can each invest everywhere. Our experience of working in places that have managers specialise was that people get very territorial, and it can institutionalise errors. What we do is that each works on things that interest us at that time.”
So there is a level of engagement you can’t always get with one portfolio manager looking after 60-70 active positions. It is not uncommon for, particularly institutionally run, long/short funds to have rules saying that there should be longs and shorts in each part of the market. To a degree that forces managers to have positions without conviction.
“Timing is quite important to us,” says Cawker. “So we spend a lot of time looking at share price behaviour and short interest as well as whether the stock is cheap or dear and at times what kind of earnings revisions profile it has. We use technical analysis to help with entry and exit points. Ideally we will be squashing out every factor risk that we don’t want to take through hedging.”
The Insight Specialist Equities team size the positions for the Market Neutral Fund by several criteria: liquidity, volatility and conviction. The last factor is not the most important “because the positions you have most conviction about don’t turn out to be your big winners,” laughs Cawker. Because the stop-loss is at 0.15% of NAV for every position, a volatile stock will have to be sized smaller, even if is large cap name. For example mining stocks, which the Insight team don’t do much in as a sector, are mostly large cap but highly volatile. In the context of running the UK Market Neutral Fund a mining position might be sized the same as a mid-250 name, even though the stock will be 10 times larger in capitalisation.
Richard Howarth, a portfolio manager who works on the fund, comments that “in contrast to long-only funds we want all our money to be active. We are not putting chips on the table for something to happen in the next two years. The idea is that each pair works now, and we rank our ideas on that basis – what is going to contribute to returns now. So timing is the main issue, and that is what drives the decision making on whether to include an idea or not.” The stop-losses are tight to ensure that pairs that are not working now are promptly closed.
The review process
An effective investment management process always includes a review by routine. Insight’s Specialist Equities team has one. Andy Cawker says that in the monthly risk meeting if a manager has a new idea, he has got to take an idea out. “You do want that capital tension when running active portfolios. We ask ourselves in these meetings is the size of position correct? A larger, more liquid stock with low volatility will allow us to have a larger position; a smaller, more volatile stock would have a smaller position. I spend more time looking at the aggregate portfolio than other team members because that is my responsibility.”
Richard Howarth expands, “What we don’t want is to have meetings reviewing each other’s positions. We have tried that and found that it is a constraint on the best ideas getting into the fund. Each manager sponsors a position into the fund, and they take full responsibility.”
The monthly review meeting from Cawker’s perspective is more about how these positions combine and contribute to risk. The managers check that they are not introducing risks they did not intend to take. This is not done by running a Barra-style factor analysis. Rather, the quantitative risk analysts (who are dedicated to the Absolute Insight range) run a battery of correlation tests which show empirically what the portfolio has moved with.
The Insight Specialist Equities team do not want to put too much weight on one measure of portfolio risk. They go through a set of outputs, including reports from Barra-style research and their own in-house developed left- and right-tail risk analysis to look at factor analysis and risk sensitivities. For example, a year ago the reports showed there was a right-tail gold risk. Further analysis showed that this was a co-movement of the whole portfolio with the gold price, but that it was not expected to necessarily be there as a forecast factor – it was a statistical phenomenon not a real world factor bet.
The other major agenda item in the monthly portfolio meeting is liquidity. “The fund is a UCITS fund with daily liquidity, so we have to be aware of our ability to add to positions and get out when we want to. We need to know where the pinch points are in execution of deals,” says Cawker. The ability to deal is one of the reasons why they have added to the number of fund managers as they have grown the assets: if it was just the three portfolio managers, as was, the team would have 30-40 positions rather than the 60-80 pairs currently run. The lower number of positions would present liquidity issues at today’s AUM.
Andy Cawker shares how it feels to run this type of fund structure: “For each position there is a lot going on: is the idea right, is the timing right and is the hedge effective? In the latter case, as events occur we want to verify that the hedge still works – when Israel bombs Gaza and markets move does the hedge do what we expect it to do?” The structure of five portfolio managers allows intense scrutiny of live positions and there is a lot of weight put on the hedge acting as expected for the specific circumstances, and the active bet side of the pair acting as it should. “We do not have to go into a room and read a report about 60 positions in the portfolio,” states Cawker. “Any report would be well after the event; our method is real-time oversight. We are each on top of our 10 or 12 pairs.”
A litmus test of quality
Like some of the best equity hedge fund managers, the Insight Specialist Equities team makes an effort in its hedging arrangements. To a degree that is intrinsic to a pairs-based investment strategy, but high-end managers track and monitor the effectiveness of their hedges, and prepare on a what-if basis. In the case of Insight, hedges can be bottom-up or fundamental. A correlation screen is run which ranks the effectiveness of theoretical hedges (sector baskets or individual stock) for a current or potential holding. The screen can prompt interesting hedges to the managers. A recent example was a pair of Tesco (a fundamental research-driven short) and Astra Zeneca (a hedge which was identified by screening). The hedge cut out the staple/defensive part of the Tesco short and left the sector and stock-specific short (based on earnings revision vs share price recent performance) in place.
An example of the dynamics of hedging was a holding in the UK Equity Market Neutral Fund of vertically integrated paper and packaging group Mondi which was initiated in January 2011. The Mondi side of the pair was the lead idea, and it was initially hedged with the FTSE 250 index to remove market risk (see Fig.5). However, Mondi is a cyclical and emerging market-sensitive stock, and so when it was picked up that the emerging market and materials indices were increasing in influence in the stock market the hedge was switched to the mining sector in February 2011. When the rotation to EM/mining had played out in the market the hedge with the broader index (the FTSE 250) was reinstated. Such careful, considered and dynamic hedging is indicative of the precision with which Insight manage their market-neutral funds.
Extending the range, and Europe
There are a couple of developments for the Specialist Equities team that should be covered: extending the range, and the European dimension. Some investors in long/short funds are prepared to take more risk for a higher potential return than the original UCITS Absolute Insight Fund could offer. The firm was asked to launch a more directional form of the fund, which they did in January 2011 on the BNY Mellon platform. It is called the BNY Mellon Absolute Return Equity Fund. It has twice the gross of the older market-neutral fund and a wider band for the net exposure to markets. The newer fund has £190m under management. This is the fifth Absolute Insight fund – the others are the UK Equity Market Neutral Fund, a credit strategy, a currency strategy and an emerging market debt.
Andy Cawker tells of the European angle for the fund: “In sales terms it has been worth something to us to have UK in the name. Using BNY Mellon distribution, we have had a lot of interest in the fund from Europe, and I’m not sure we could have got that if we had started out with a pan-European mandate. As it is, we can have up to 20% of the gross of the fund invested outside the UK, and so we have added Dave Headland to our team. Dave invests in European shares for us, and used to run a long/short European equity fund. So he adds to our capacity, increases our opportunity set, and is another source of alpha within the team. In addition he can give us some valid comparisons and insight into sectors which are better represented in Continental Europe than in the UK, like the paper stocks.”
The Insight Specialist Equities team at one time ran long/short and long-only funds at the same time. That did not last long, and Richard Howarth explains why: “When the three of us got together to run the UK Equity Market Neutral Fund in 2005 we were running segregated pension fund mandates as well as the market neutral fund. We quickly worked out that we did not want to run traditional long-only and long/short funds at the same time. Mentally it can be difficult to short a stock just for a hedge (we may not fundamentally dislike it) in one fund and have to invest in a benchmark position elsewhere. So we stopped running long-only a year after launching the market-neutral fund to concentrate on the long/short fund.”
A good fit
The Absolute Insight UK Equity Market Neutral Fund is run by Andy Cawker’s team with an investment approach and structure that is a very good fit for the sort of outcomes they are trying to produce. The production of 78% positive months is a testimony to that. The sources of alpha are diversified by number of positions, and by style, as each fund manager is able to bring their own idiosyncratic selection preferences to the process.
The number of positions per portfolio manager enables an intensity of observation that is not possible in a one-man or two-man management team. The consequence is that minor deviations in expected behaviour in either the lead idea side of the pair or its hedge are spotted and assessed/addressed immediately. That routine of intense oversight and the stop loss-discipline and the timing skills in putting positions on gives the funds every chance of fulfilling the necessary operating characteristic of successful equity hedge funds – that is, having a majority of the capital contributing positive returns over any time frame.
There used to be a minor caveat that there was a lot of effort expended to produce low (but consistent) absolute returns. The introduction of the second fund addressed that at a stroke, and that the team now runs nearly £900m is an absolute vindication that there can be a tight correlation between a thoughtful structured approach to generating and structuring alpha sources and commercial success.