The absolute return peer group is incredibly mixed, ranging from funds which are aggressively levered through to those which actively hedge risks. Fund styles, asset mixes and processes vary widely too. Like most of our absolute return peers, we have a broad ‘mandate’ by prospectus, but we practice a process that leads us to behave in a certain fashion. But when we compare our fund’s risk profile to its peers, it seems markedly different from almost all of them.
More specifically, the fund is negatively correlated to equities and to most equity funds. It also seems to enjoy most market ‘shocks’, which differs from the majority of funds (in technical terms, the fund is slightly ‘long volatility’). I often wonder, given the flexibility offered to rivals, why more of them don’t do something similar to us? Are we missing some important point, perhaps? Investors know that a fund whose returns are negatively correlated to those of a major asset class can be extremely useful as part of a suite of funds, because it will almost always lower the risk, help defend against shocks and reduce the potential ‘drawdown’ or loss.
Benefitting from volatility
The reason for our strategy’s negative correlation with equities is simple: it has more short positions than long positions, as a result of our stock-picking. And it has had a negative correlation to equities since mid-2015, so it’s not a recent phenomenon. And why are we long-volatility? This is for two reasons. First, sharp increases in volatility tend to be caused by ‘bad’ news, which sends the market lower. Being net short (and within that, shorting some high-beta stocks) the fund tends to enjoy such shocks. Second, we usually own a small number of options as simple hedges against shocks, and this means the fund has assets that can go up sharply on certain types of bad news.
For some time, I’ve been surprised that there are not more funds with a negative correlation to a major asset class, such as equities. Here are my best guesses as to why:
- It’s just too painful to run a fund like this. It takes a certain resilience to endure the down days when almost everyone else seems happy and relaxed; to fight the long-term upwards trend of the market (even when the medium-term outlook seems challenged). I’m sure there is above average ‘career risk’ for someone doing something like this, too.
- This kind of fund requires crystal clear communication, and lots of it! We’re fortunate to have a client base which knows our fund well and uses it for the right reasons. But because we behave differently from other funds and asset classes, we need to put in more work in explaining performance, attribution and risk.
- Active funds need ‘alpha’ (or risk adjusted out-performance) and we need to demonstrate how we add value. If we didn’t have an ‘edge’, we’d simply lower the risk of a suite of funds with no value added; using cash or index futures would be just as effective and a bit cheaper too. Our source of alpha (our ‘edge’) we believe comes from our process for single stock short-selling and an edge around ‘data’ and ‘behaviours’. This is unusual and needs articulation. And of course, sometimes your area of specialisation can work against you and this leads to a greater need for communication and explanation.
All in all, the painful distribution of returns and the need for exceptional communication makes our approach hard to practice. Even when huge swathes of assets appear over-priced on any kind of meaningful time horizon, it is difficult for fund managers to act on this knowledge. And yet, a fund that can help lower risk, defend when defence is needed (on a market shock) and reduce large losses across a suite of funds is potentially very useful for our clients. And if we also add ‘alpha’ by doing something well, then that could become extremely valuable to our clients. For that reason, we’re willing to do what we think is the right thing. We’re just surprisingly uncommon in doing so.