What defines an absolute return strategy built to last?

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.