What defines an absolute return strategy built to last?
As much as some things change, others stay the same. Portfolio Manager Luke Newman considers how strong collaboration and communication, aligned with a solid, repeatable process, are key to running an active equity long/short strategy throughout the cycle.
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6 minute read
Key takeaways:
- The normalisation of interest rates is shifting financial markets away from irrational valuations towards a renewed emphasis on company fundamentals, creating significant opportunities for stock pickers.
- A return to fundamental analysis, driven by changing market dynamics, is enhancing the effectiveness of equity long/short strategies, signalling a more rational and rewarding investment landscape.
- We believe that an equity long/short strategy that prioritises consistency in its process, while being adaptable to market changes and evolving technologies, can offer a useful solution to investors with long-term absolute return objectives.
A defining feature of financial markets is the process of adaptation and evolution, from the industries and technologies we invest in, to the various investment products that investors can use, and how we categorise them.
During my time working with the asset class, equity long/short strategies have been classed as various things by investors, from absolute return and liquid alternative strategies to portfolio diversifiers, etc. Absolute return is naturally a broad church, making it a useful place to put anything that in theory adheres to the concept, but our concerns have always been that it is difficult to try and compare so many different kinds of strategies that bear very little resemblance to what we do.
The baseline for any absolute return product is to deliver a consistent real return regardless of market direction, with the potential to preserve capital or generate positive returns in weaker periods – a true ‘absolute return’ solution. For that reason, we have tried to stay focused on that simple purpose. By focusing on large-cap developed market equities, factoring in no complex derivative instruments, we believe it is possible to create a strategy that can match investors’ absolute return objectives, with reliable liquidity and clear, communicable investment rationales.
Twenty years of collaborating on equity long/short
When it comes to managing a strategy in a constantly changing environment, collaboration and communication are just fundamental, so you need a good relationship with your co-workers. I met Co-Manager Ben Wallace when he interviewed me for my first graduate job at what was Morgan Grenfell Asset Management (then Deutsche Asset Management), way back in 1998. Although I cannot recollect specifically what we discussed, given that I was one of those unusual people who knew from an early age what I wanted to do, I imagine my earnestness was overly apparent!
We went our separate ways, but I can remember much more clearly when opportunity brought us back together at Gartmore, which is where our partnership started. Gartmore was subsequently acquired by Henderson in 2011, which later merged with Janus in 2017. Ben and I, and our excellent analysts Gary Thomson and Dan Davies, have known each other for a long time. We get on very well away from the screens and I think this has given us the ability to be very direct when it comes to debating stocks and markets.
It is fair to say that Ben and I probably have complementary investment approaches and areas of focus, but nothing that is set in stone. It has become very clear to us over time that our highest hit rate comes when we converge on a particular idea or theme. We take it seriously when the other disagrees, or even has a little less conviction towards a particular investment. In those circumstances we tend to adopt an opposing ‘Devil’s Advocate’ approach to discussions to help keep each other honest.
Always a learning curve
For me, the biggest joy and equally the biggest challenge of this job is that nothing is constant. You need to stay flexible and open to change, but we have found that if we can maintain consistency within the investment process and remain open to opportunities, then you can reap the rewards over time.
The past two decades has seen an explosion in available data and information sources for investors. A big part of how we have evolved as investors is to try to filter this data effectively and to prioritise time – in person if possible – with the executive teams of the businesses we are analysing and investing in. As a screening tool for new ideas and as a mechanism for testing your own views of companies and industries there is no better use of our time. We have also been very open to optimising the use of technological advancements to help assess changes in market structure or technical factors. But that is far from the only change.
The question of fundamentals
We have seen a lot of discussion in recent years about whether company fundamentals are more or less important than they used to be, in terms of long-term investment returns. We had some strong opinions on this in the summer of 2022. After a near-decade of ultra-loose monetary policy (low interest rates), our view was that, as the US Federal Reserve and European Central Bank began normalising the cost of money (increasing interest rates), it would reignite interest in underlying company fundamentals, and reinstate valuation as a significant factor in equity markets. We believed this was key to creating an environment that once again suited stock pickers.
Pleasingly this has proven correct, both in the potential return for stock pickers, and the potential for higher consistency of returns – in other words, the potential to find more sources of positive return and the ability to potentially mitigate against market sell offs. Right now, with stock dispersion elevated, as we see clearly in Europe at present (see chart), we see an environment ripe with opportunities on both the long and short side.
Elevated stock dispersion has opened the door to stock pickers
Source: Morgan Stanley, Factset, Bloomberg, 31 May 2024. Index used: MCI Europe. Shows European stock dispersion relative to index volatility, over three and six months. Past performance does not predict future returns.
Why has this happened? During the post-financial crisis era, zero or near-zero discount rates drove an irrational pricing of ‘growth’ assets, with valuations (eg. price/earnings ratios) expanding exponentially as forecast future cash flows were discounted by an ever-shrinking number. As interest rates return to historical norms, we are seeing a reversion of valuation techniques, intra-market dispersion and importantly investor behaviour, all revert to the established patterns of the pre-ZIRP (‘zero interest-rate policy’) era.
The macro inputs still matter of course, but clearly the impact of a 0.25% move in rates from this level, versus a starting point of near-zero, is less significant. This leaves room for company fundamentals to once again be the primary driver of share price movements; margin structure, balance structure, quality of management and incremental movements in profitability reflected in valuations.
We have also seen a change in executive and board behaviour, prompted by changes in both alternative and more traditional approaches to value creation. These have included a pickup in merger and acquisition (M&A) activity, changes to group structures and better capital allocation as companies seek to invest in areas that ordinarily drive profitable growth.
Where next for equity long/short strategies?
Demand for absolute return strategies was on a downward trend until recently, reflecting the market environment. For equity long/short strategies, however, since 2022 it has been as good as we have seen it. Given alpha opportunities for fundamental stock-pickers have come roaring back, we believe we are in a strong position to construct portfolios that are arguably more robust, in terms of macro risks, due to greater individual stock dispersion. Flow dynamics for equity long/short strategies have turned favourable, which again seem logical given the risk/reward proposition of the asset class versus traditional equity, fixed income or money market funds. Confidence is higher than we have seen in a decade, and we are optimistic that this more rational market environment can continue.
Absolute return: A type of investment strategy that seeks to generate a positive return over time, regardless of market conditions or the direction of financial markets, typically with a low level of volatility.
Active investing: An investment management approach where a fund manager actively aims to outperform or beat a specific index or benchmark through research, analysis and the investment choices they make.
Alpha: The difference between a portfolio’s return and its benchmark index, after adjusting for the level of risk taken. The measure is used to help determine whether an actively managed portfolio has added value relative to a benchmark index, taking into account the risk taken. A positive alpha indicates that a manager has added value.
Capital allocation: The allocated spending of a business on various parts of its organisation, such as employees, equipment, technology or infrastructure assets.
Cash flows: The net balance of cash that moves in and out of a company. Positive cash flow shows more money is moving in than out, while negative cash flow means more money is moving out than into the company.
Discounts: Refers to a situation when a security is trading for lower than its fundamental or intrinsic value. In financial terms, discount is the amount by which a share price is lower than the net asset value of a business, usually expressed as a percentage.
Fixed income: Debt securities, or bonds, issued by a company or a government, used as a way of raising money.
Growth assets: Companies where earnings are expected to grow at an above-average rate compared to the rest of the market, and therefore there is an expectation that their share prices will increase in value.
Liquid alternatives: Easily traded investments that are not included among the traditional asset classes of equities, bonds or cash.
Long position: A security that is bought with the intention of holding over a long period, in the expectation that it will rise in value.
Short position: Fund managers use this technique to borrow then sell what they believe are overvalued assets, with the intention of buying them back for less when the price falls. The position profits if the security falls in value.
Long/short: An investment strategy that can invest in both long and short positions. The intention is to profit from combining long positions in assets in the expectation that they will rise in value, with short positions in assets expected to fall in value. This type of investment strategy has the potential to generate returns regardless of moves in the wider market, although returns are not guaranteed.
Macro: Macroeconomics is the branch of economics that considers large-scale factors related to the economy, such as inflation, unemployment or productivity.
Margin structure/balance structure: Margin structure is the breakdown of what portion of a product’s value can be attributed to each part of its creation process. Balance structure is the same process for a company’s overall revenues and outflows.
Monetary policy: The policies of a central bank, aimed at influencing the level of inflation and growth in an economy. Monetary policy tools include setting interest rates and controlling the supply of money.
Money market funds: Strategies that invest in short-term and highly liquid fixed income instruments that can be quickly and easily converted to cash.
Derivatives: A financial instrument for which the price is derived from one or more underlying assets such as shares, bonds, commodities or currencies. Futures, options and swaps are all examples of derivatives.
Price/earnings (PE) ratio: A popular ratio used to value a company’s shares, compared to other stocks, or a benchmark index. It is calculated by dividing the current share price by its earnings per share.
Share price: The price to purchase (or sell) one share in a company, not including fees or taxes.
Stock dispersion: How much the returns of each variable (eg. stocks in a benchmark) differ from the average return of the benchmark.
Volatility: The rate and extent at which the price of a portfolio, security or index, moves up and down. If the price swings up and down with large movements, it has high volatility. If the price moves more slowly and to a lesser extent, it has lower volatility. The higher the volatility the higher the risk of the investment.
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Le performance passate non sono indicative dei rendimenti futuri. Tutti i dati dei rendimenti includono sia il reddito che le plusvalenze o le eventuali perdite ma sono al lordo dei costi delle commissioni dovuti al momento dell'emissione.
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