Market-Neutral Strategies Prove Their Worth

Coverage of the 2010 Investment Innovation Conference.

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gear shiftWith the S&P down roughly 15% since 2000 – a decade bracketed by a tech bubble and a global financial crisis – institutional investors have found it more challenging than ever to find strategies that can generate returns and mitigate risk in volatile markets. Whatever their definition of volatility, be it funded status or asset returns, investors share a common focus on risk management, as well as a growing predilection for alternative strategies that can reduce risk and enhance returns. Given this perspective, increasing attention is being paid to the benefits of market-neutral strategies.

A period of volatility and change

The alternative investments industry offers a very broad and diverse product array that includes private equity, real estate, infrastructure and hedge funds. The industry has changed tremendously over the past several years. In the hedge fund sector, since the performance lows witnessed during the second half of 2008, when hedge fund assets stood at about $1.3 trillion, institutional investors have continued to return to the benefits offered by many hedge strategies. As a result, hedge fund assets were approximately $2.4 trillion at the end of November 2010. However, the average hedge fund had dramatically reduced its use of leverage, a measure that only now is rising again. Hedge funds have also changed their directionality: in 2008, most were running about 75% net long. More recently, that level declined to about 53%.

Significant changes in regulation and investor perceptions have also affected the alternative investment industry. As a result, the industry has been significantly shaken out in terms of the number of managers and players. Since 2009, some 3,500 hedge funds or their management companies have gone out of business.

For the survivors, however, returns have improved. Through October 2010, the Credit Suisse hedge fund index was up about 8% for the year. Most strategies, with the exception of emerging markets and dedicated short bias, are now generating returns. According to various industry sources, as at October 2010, approximately 85% of managers are above their high-water mark.

Market-neutral strategies stand out

Of the various approaches, market-neutral strategies have performed well over the long term, as well as in unsettled markets. The idea behind market-neutral strategies is simple: if you are long a dollar of stock, you will be short a dollar of stock. If the beta of your long portfolio is one, the beta of your short portfolio is one. In other words, you have no beta relative to the market, and no dollar exposure. There are no sectors, regions, capitalizations or investing styles. What you’re doing, in essence, is looking for manager stock selection performance to drive returns.

Market-neutral strategies have shown they behave well in unsettled market environments, and they do well in rising-rate environments because, again, investors are emphasizing manager skill rather than market directionality. Both quantitatively and fundamentally based market-neutral strategies work well at different times and in different environments. And typically, clients and consultants blend managers with both approaches.

Market-neutral strategies also provide much lower volatility over the long term. They have very, very low correlations to traditional and alternative asset classes, and even, in many cases, negative correlations. Over all, they produce solid risk-adjusted returns while having the characteristics of liquidity and low leverage.

Additionally, investment committees find it very easy to understand market-neutral strategies. Good managers can offer complete transparency into their portfolios, so that committees will know what’s going on.

Due diligence is the sine qua non

But no strategy works without operational due diligence. The infrastructure and compliance associated with running a hedge fund have moved from obscurity to the spotlight, where they should be. Operational due diligence is no longer a one-time exercise when an investment is made, but an ongoing dialogue with the investment team. With due diligence properly addressed, investors can effectively employ market-neutral strategies to enhance risk-adjusted returns.

Joe Morgart is senior vice-president of Alternative Investment Strategies, Pyramis Global Advisors

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