Hedge fund managers look for better returns from equity markets

Hedge fund managers and allocators expect this year to be kinder to the equity hedge strategy than 2010 resulting in better returns.

Last year whipsawing markets damaged many while a lack of dispersion between shares and high volatility benefited few.

Allocators are hoping for better returns from equity market managers this year compared with the modest 10.4% recorded by the HFRI Equity Hedge (Total) Index in 2010.

One multi-manager said his lasting memory of 2010 would be of seeing equity managers adjust net exposure as markets reversed, only to see direction switch again, hitting them on the rebound.

Managers divide 2010 neatly in two: the ‘macro months’ of January, May and November, and months when company fundamentals meant something in February, March, September and October.

Anthony Lawler, head of portfolio management at Man, notes managers had to navigate the worst August for US shares in a decade, followed the next month by US markets’ third-best month in 10 years.

“Going through such a violently choppy climate, it was challenging to have a set of equity hedge managers protecting capital and then producing positive returns,” he says.

At International Asset Management (IAM), Sean Molony, senior investment specialist, says, “The performance of long/short equity hedge funds has been slightly above the average global hedge fund’s but only slightly. We expected the level of outperformance to be higher.”

He adds, “The returns have got to get higher next year, and we would expect them to be driven by more fundamental stock selection, rather than simply risk-on then risk-off.”

Last year was an exceedingly tough one for stock pickers. One study by a major US bank said less than 5% of share price moves in 2010 could be attributed to company-specific factors.

However, as big picture concerns over European debt, a Chinese hard landing, lack of US growth and possible effects of Basel III on banks are gradually relieved, fundamental drivers will be able to reassert themselves to an extent, according to Ben Funk, head of research at Liongate Capital Management.

Already the largest hedge fund strategy measured by assets, equity long/short can expect healthy inflows from investors who number it among their favourite sectors for this year.

Key indicators show US shares are historically cheap, dividends and mergers and acquisitions (M&A) are expected to grow and shares are starting to react more to fundamental factors rather just to changes in the general appetite for risk.

Liongate’s Funk says equity hedge managers have a universe which is as cheap as it has been since 1980 when gauged by the S&P 500 earnings yield over the 10-year Treasury yield.

“Dividend payout ratios and yield differentials also offer a similar story,” Funk adds.

“The Vix below 20 – compared to at 46 in May [2010], and the volatility of Vix falling, too, is a much more favourable environment for long/short equity traders. Last year showed that managers who are able to shift their net and gross nimbly as market regimes change will be the best performers in this type of an environment,” he adds.

Liongate cut its allocation to equity long/short from the mid-20% range in the middle of 2007 to minimal levels in 2008. Now it is boosting exposure again as is IAM.

Simon Savage, co-manager of GLG Partners’ European Long/Short fund, says dispersion between stock prices should increase in 2011 as analysts revise forecasts and greater differentiation emerges between highly and less leveraged companies as well as between companies with and without non-Western earnings exposure.

“It will then be up to us to have the skill set to turn those opportunities into returns,” Savage notes.

The skill, he says, will consist mainly in the ability to switch between being a stock-picker when fundamentals rule markets, to top-down investing if macroeconomics come to dominate.

According to Savage in 2010 the degree of investor worry about the macro picture was demonstrated by the fact markets rewarded analyst-beating earnings reports only briefly, if at all, before a company’s shares sank again as macro fears took centre stage.

Andrew Weir, portfolio manager at investor Stenham Advisors, says the main potential headwind in 2011 for equity long/short would be a continuation of the risk-on/risk-off dynamic and an “indiscriminate macro driven-investing environment where the opportunity set for fundamental stock pickers to generate alpha from long and short positions is diminished”.

Despite there being more differentiation between S&P 500 stocks late in 2010, Weir says “we could see continuation of quantitative easing in 2011, and sovereign or even local government debt issues could once again come to the fore.”

Amid changeable markets Morten Spenner, IAM’s chief executive, prefers variable bias funds to structurally long- or short-biased managers, largely for the ability of variable bias to adjust exposures with market direction.

The long/short equity managers in which IAM invested have typically moved their exposures significantly several times last year. Returns over the year to November 30 ranged from 2% to around 30%.

However, Molony notes there has been some difficulty finding enough trading oriented managers. IAM says it would allocate more to this area if they could find additional managers that meet their criteria.

“If the recovery has legs then – absent war in Korea or major sovereign default in Europe – there may be lower earnings growth. But markets would be acceptable. There are lots of assets to leverage non-European growth among German and British exporters. There is lots of fuel around as far as long/short is concerned,” declares GLG’s Savage.

He says the equity hedge strategy is also fuelled by the fact companies and industries within Europe have “differing degrees of sensitivity to the forces driving sovereign default risks in Europe, as well as the policies that will be thrown at the problem as events unfold”.

Paul Marriage, manager of Cazenove’s UK Dynamic fund, says opportunities abound for his strategy, too. To show its commitment Cazenove is re-opening this fund to investors and wants to add around $75 million to its current $250 million assets under management (AUM).

Marriage says many investors will look back on 2010 as a year “where some companies delivered enormous earnings growth of 40% or 50%”. Mid-teens growth, however, is more likely in 2011.

“People are pretty cautious about this year and how aggressively earnings growth will be extrapolated from 2010 to 2011,” confirms Marriage.

He sees the key to success in identifying which companies face high earnings forecasts that they will not be able to achieve compared with those that will meet expectations.

“I am looking at stocks to see if I am as confident as I can be this year’s expectations are realistic, and whether or not they will be achievable,” he notes.

He believes there are still “cheap gems” in his UK universe but also high P/E, high growth companies “currently priced to perfection, but which in a rougher environment may struggle to grow”.

The US findings of a survey of equity hedge fund managers by TrimTabs and BarclayHedge late in 2010 suggest short books will come in handy this year. Almost 40% of respondents to TrimTabs’ research expect US shares to fall compared with 31% who were bullish.

However, they were not shy of seeking to profit from the market, regardless of its direction. Only 9% of managers expect to cut gearing. This is the smallest proportion since May 2010 while 16% plan to increase it.

“The Fed is begging firms, consumers and market participants to take risks, and hedge fund managers are capitalising on kind conditions,” says Vincent Deluard, TrimTabs executive vice president.

“They view quantitative easing as an asset-price gift horse, and hedge fund investors have handed them $33 billion in recent months. Also, it certainly doesn’t hurt that managers can borrow to buy assets for virtually nothing courtesy of historically low short rates,” he continues.

“At the same time the rolling 12-month beta of hedge fund returns sits below the long-term average, and that of equity long-short funds is dipping below zero. Managers remain very reluctant to make directional bets on equities,” concludes Deluard.

Richard Cardiff, co-founder of London-based but Asian-focused Coupland Cardiff Asset Management, says the “outlook in Asia is much more favourable than in the West and we this to continue for some considerable time. Economies do not have personal, corporate or government debt and therefore are in a much better state than counterparts in the West.”

He continues: “Management at companies are seeing a very positive environment, driven by demand from the East and a small pick-up in demand from the West. The domestic consumption story which many have spoken about over 2010 is finally starting to take hold and will be another key reason for Asia’s outperformance of western markets.”

Cardiff predicts quality companies this year will outperform low-quality cyclicals. He also believes, in contrast to some of his developed market counterparts, “a buy-and-hold strategy will offer more opportunity than a trading strategy, due to the inherent difficulties of predicting the vagaries of government policy and macro factors.”

Trying to predict market direction and government moves will end in whipsawing, an experience many managers will hope they have put behind them after 2010, notes Cardiff.

“The key elements for 2011 are to stick to your process, focus on those quality names that can deliver and try to avoid spending too much time trying to react to every policy or macro twitch, you will be rewarded,” he says.

IAM’s Spenner appreciates the willingness of managers in Asian stocks to switch their bias as markets move. “If you look at the indices in China and Hong Kong, you have had a real rollercoaster from 2007 to 2010 and the managers left standing there have been through all of that, so they appreciate just how difficult it is.”

Jean-Charles Guillemin, investment analyst at Stenham, believes building positions in Asian markets became easier last year after “massive inflows” including a record $6.4 billion of foreign capital into India in September.

“Some of our Japanese managers reported liquidity improving (which means) they can now build 2% positions in one day for 40 names, while that was limited to 30 names only in August 2010,” he says.

Nevertheless, Guillemin is mindful of liquidity in the region. “We try to make sure our Asian managers have at least $100m under management and we generally tend to avoid managers with significant small cap exposure, despite slight improvements of liquidity, to avoid any liquidity mismatches within the portfolio,” he says.

Stenham’s Weir says any drop-off in correlations in equity markets generally “should intuitively make for a better environment for long/short stock pickers”. Equity hedge remains one of Stenham’s core allocations, not least because the company believes “some of the highest quality hedge fund investment offerings operate in this space. The strategy also has the benefit of being liquid and transparent, and allows for diversification within the strategy across geographies, sectors and investment styles.”

Analysis by IAM of industry data shows equity hedge fund managers on average are skilfully picking the right shares. Those stocks with the highest concentration of hedge funds among holders roughly doubled in value in the 18 months to last September compared with around 35% appreciation in those with the lowest hedge fund concentration.

“Implied correlation has come down, which makes for a better environment for fundamental stock picking. We also believe you will continue to see differentiation in stock prices,” says Funk.

Man’s Lawler says his company currently has a “strong preference” for managers with years of proven trading abilities in choppy markets as well as the ability to limit losses as markets fall, yet also to capture upside when they rally.

“Managers who have done the best (in 2010) generally have demonstrated this prowess and have moved net exposure around significantly during the year,” he comments.

Ana Haurie, chief executive of fund of hedge funds promoter Dexion Capital, says basic stock-picking skills will re-emerge as a differentiator. These qualities “took a back seat” for three years while factors such as availability of finance and risk-appetite generally dominated.

“Correlations are falling and we expect company fundamentals to have an increasing impact on long-short returns,” Haurie concludes.