Union’s first move into liquid alternatives in 2009 was implemented though external manager selection, which is still run by a separate team. In-house liquid alts management began in 2017 with an equity long/short strategy, initially in a swap account, before the UCITS launched in 2019. “We wanted to get the structure set up and reporting right before starting the UCITS, and we already had a live track record before the UCITS launched,” says Edmund Keferstein, Head of Liquid Alternatives and Thematic at Union Investments, based in Frankfurt am Main.

Union’s vision for liquid alternatives

Keferstein explains where, how and why liquid alternatives fit into portfolios at Union: “We use liquid alternatives as diversifiers for retail mutual funds, multi-asset mandates and institutional investors. We expect liquid alternatives returns to diversify equities, interest rates and credit spreads. This diversifying aspect is as important as performance. We are not looking for high single-digit or double-digit returns”.

In total, Union has EUR 4.6 billion in liquid alternatives, of which EUR 3 billion is externally managed. The EUR 1.6 billion of internal capital is a notional figure that includes some assumptions about risk budgeting. The internal strategies are 90% funded with proprietary capital and 10% by external investors. “The large internal allocations show the high conviction that senior management have in our strategies. They have plenty of capacity and we expect to raise more institutional assets,” says Keferstein.

Liquid alternatives can be accessed through derivatives overlays, though some institutional clients cannot trade these sorts of instruments and prefer UCITS funds. There are now two single strategy liquid alternatives UCITS funds trading strategies that are also run pari passu as modules of a multi-strategy fund.

Synergies within Union Investment

In-house liquid alternatives also include an internal fixed income long/short program. “There is a lively debate and exchange of asset class views within the alternatives team, promoting cross-fertilization of ideas between equities and bonds,” says Keferstein.

The equity long/short team also work closely with Union’s long only equity portfolio managers. Union also has an internal global equity market neutral strategy, using a more top-down thematic basket approach, in co-operation with the long only equity teams.

Union has strong corporate access that all teams benefit from. It conducts about 4,000 company meetings per year and attends many global conferences. “We can attend or host company meetings, and there are a lot of synergies. Being part of one of Germany’s largest asset managers, which managed over EUR 450 billion as of year-end 2023, ensures good access to brokers and banks. We can play brokers off against each other to get better execution,” says Merkel.

Union’s 35 long only equity managers can pitch ideas to the hedge fund teams, but they are also free to short any stocks owned elsewhere. “We have so many long only funds that our shorts are bound to be found somewhere in another fund,” reveals Merkel. Indeed, the style overlap between the long only and market neutral strategies is limited, and this is by design. “Our alpha pattern looks very different from a typical Union long only performance. Union has a bit of a bias to quality and growth factors, but you cannot see that in our alternative products. It is important for us to diversify internal long only strategies that make up the equity sleeve of multi-asset funds.”

Additionally, the sector coverage of the long only products is now different from the equity market neutral one. The UCITS initially traded all sectors before refocusing on four core sectors: financials and industrials, covered by Merkel, and both consumer staples and consumer discretionary, covered by portfolio manager, Oliver Terhechte. “We might have a trade in other sectors if we see a good pair, but we do not have to be exposed to energy or healthcare and can sometimes only be invested in our four core sectors. Philosophically we would rather focus on sectors where we have the best expertise, and bring some alpha to the table,” says Merkel.

The investment universe is about 400-500 European stocks in the four core sectors and 900 or so meeting the liquidity criteria and a market capitalization above EUR 600 million. A filtering process narrows the pool into candidates for the portfolio. Research and company meetings, as well as quantitative, fundamental and technical screening, eliminate two thirds of them, and this group changes all the time. To put on a trade, Union needs to form a view different from consensus, which could be related to earnings forecast or valuation multiples, or both, or indeed inspired by other items such as one-off event catalysts. “However, in practice the most common disagreement is going to be on valuation multiples. Realistically, two people cannot build earnings models for 500 stocks, though we might more broadly be above or below consensus on earnings forecasts,” admits Merkel. Of 21 managers in absolute return, the product is mainly managed by Merkel and Terhechte, with two others active in equities providing some input, and four or five more having some involvement. Another portfolio manager, Jonas Horsch, who previously worked for Walleye Capital and Millennium Management in London, started in June 2024.

Market, macro, currency and factor neutrality

Whereas some market neutral strategies, and especially quantitative ones, can run thousands of positions, this strategy is more concentrated, with between 100 and 150 stocks, and a maximum position size of 5%. Nonetheless, beta, country, industry, currency and factor risks are closely watched. There is some very small latitude to go 2-3% net long or net short, but not 20-30%. “The product can in theory go to plus or minus 30% net exposure but in practice does not go wider than plus or minus 5%. We might sometimes go up to 10% net long but would never go down to minus 10%,” says Merkel. The portfolio does not express structural macro or currency views. Since the strategy is not country neutral, its raw positions might have some long or short exposure to currencies such as the British pound, Swiss Franc or Swedish Krona, but these are hedged back to the Euro base currency.

The approach was always broadly market neutral, and the investment process is old school bottom-up discretionary, though some proprietary quant screens and tools are used, for instance to help with measuring factor exposures.

In investment pairs, Union tries to find similar risk factor exposures, such as BMW versus Mercedes within the German autos sector. Most of the trades are sector neutral pairs but they do not always have to be a country neutral pair. “For financials we are sensitive to stronger domestic drivers, but we might still trade something like a Spanish bank versus an Italian bank,” says Merkel, who has previous experience of running both discretionary and quantitative strategies.

There is very limited tolerance of style and factor risk, which is checked on a daily basis. Sensitivity analysis closely monitors the size, value, growth, momentum, quality, cyclical, commodities, Brent crude oil, German government bond bund future, VSTOXX (volatility of Stoxx European equity index) factors and aims to keep them low in general.

Some country-based valuation differences are not, however, being traded. “We think there remains a UK valuation discount that we do not expect to close. As examples of the relative unattractiveness we see more UK companies trying to relist in the US or IPOs done in other markets (like CVC in Amsterdam),” points out Merkel.

Short alpha

The long book is 100% single stocks whereas the short book is 70-80% single stocks and 20-30% sector futures.

Since inception shorts have generated slightly more alpha than longs, with a 60% short/40% long split but in the first few months of 2024 longs have been in the lead. Nearly all the returns are idiosyncratic or stock specific risk; the small directional views have made only a marginal contribution to returns.

Union have nearly always been able to borrow the stocks they wanted to short, and at an acceptable cost. “There were a few exceptions when the stock borrow cost was too high, but most of the time, 98% of the time, there was no problem at all. The Covid period restrictions did not cause issues,” confirms Merkel.

The most notorious German equity short of recent years was perhaps Wirecard. Union’s market neutral strategy held it long and short at different times. It had diminished to a very small short position when it went bust. “This is because the position gets smaller on the way down, and usually we also cover some of the short as it falls,” explains Merkel. Union can sometimes be in such popular and crowded shorts. “We are aware of the risks of a short squeeze, and we do monitor these positions so that they are not too large a part of the short book. We usually set a stop loss on shorts, though we sometimes have leeway to react differently,” says Merkel.

Tactical sub-strategies

Strategic relative value is the core strategy, making up an average of two thirds of the book. The three tactical strategies: mean reversion, momentum and special situations, are more opportunistic. “Some of them, such as placements, are event specific, and there might be a lot of exposure or there might be none,” points out Merkel. “IPOs invested in would be on a normal participation basis with no underwriting,” he points out. For the special situations’ strategies, fundamental analysis can play a smaller role with technicals, sentiment and positioning more important.

Within strategic relative value, the key factor drivers are the business model, good management and relative valuations where discounts or premiums are not justified versus peers. “Medium to long term valuations can play out over different timeframes. If it happens in two weeks we might take a quick profit, or we may wait a year,” recalls Merkel. In contrast, the mean reversion strategies, which wager against overreactions, could be much shorter term and sometimes even within days on earnings news spikes. Momentum could be followed in single stocks, sectors or styles over short to medium term timeframes, somewhere in between the core strategic strategy and the mean reversion.

Variable volatility targets

The UCITS fund started with higher leverage and risk limits before tightening them up. Its annual volatility has ranged between 1% and 3%. In 2023 volatility of 1% undershot the target partly because one of the co-managers left in mid-2023 and exposure was run at lower levels.

A higher volatility target could be run in response to investor demand, probably in a separate account. “However, when seeking a higher volatility target in liquid alternatives, we would suggest a multi-strategy bundle for more diversification across a wider range of strategies,” says Keferstein.

Income from cash

In April 2024 the fund was sitting on 100% cash and earning about 3.5% interest. The cash is invested by Union’s money market experts, with very low risk and duration.

Union was founded in 1956 and was a relatively late entrant to liquid alternatives but has made a strong start. Readers should watch this space as more strategies are opened up to outside investors.