The Rise of the Super Sector

Coverage of the 2011 Investment Innovation Conference.

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story_images_Canada-flagMore than ever before, plan sponsors are focused on managing volatility risk, especially as we head into 2012, a year that promises even more uncertainty and bad news for world markets. To help, many pension funds have turned to market neutral strategies to mitigate volatility risk. These strategies, if done properly, can reduce volatility and provide attractive risk-adjusted returns. In Canada, however, the high concentration of companies within a small number of sectors can make the market tricky to navigate. This is why market neutral strategies that apply a sector neutral approach to Canada can go beyond these limitations and generate alpha for investors.

There are a few major reasons investors like market neutral strategies. To start, they offer low correlations to traditional asset classes like fixed income and equities – and also to other hedge funds. And, most importantly, they offer lower volatility over market cycles along with downside protection at the worst times. Consider that between 1990 and 2005, the standard deviation of market neutral returns ranged from 3.1 to 3.9% depending on the arbitrage strategy used by the portfolio manager. Compare that to the S&P 500 during the same period, with a standard deviation of returns at about 14.4% (and nearly 18% for the TSX). These indices also tended to have much lower Sharpe ratios over the same period.

But what about the Canadian experience? To be sure, the hedge fund industry in this country is small compared to the global universe. But it is growing. Assets under management in Canada have grown from just $5.4 billion in 2003 to $20 billion today. The hedge fund industry here has also become more robust due to the growing availability of short liquidity in the Canadian market. Indeed, the value of lendable equity securities in Canada has doubled in the last three years and now sits at nearly $400 billion.

Yes, the size of the market matters — but what makes the Canadian market truly unique is the role that sectors play. Canada’s equity market is highly concentrated in just three key sectors – energy, materials and financials – and there isn’t much liquidity in between. Dealing with this level of sector concentration presents a major challenge to managers of market neutral strategies, especially if they stick to simple Barra factors as a way to explain return variance. Barra factors include basics such as yield, volatility, value, size, momentum, non-estimation universe, growth and financial leverage.

This approach works in many global markets – but in the highly concentrated Canadian market, they fall short of explaining what drives performance. Because sectors are a major driver in Canada, market neutral investors here must pay close attention to the role they play in a specific strategy.

Taking a sector neutral approach

For Canada, a “sector neutral” approach is key. Achieving this means going beyond energy, materials and financials and truly understanding how the different sectors in the Canadian market work together. This can be done by looking at the performance of “super sectors” that better reflect the fundamentals of the Canadian market. These super sectors, which are groupings of sectors with similar characteristics, are divided into resources, consumer, industrial and interest-rate sensitive. Super sectors provide key insights into where alpha lies in the Canadian market – and they also explain a good portion of return variance and dispersion.

Investors looking for a market neutral approach in Canada should make sure that managers are looking closely at the impact of all the sectors in the market. Only then can a strategy offer the necessary risk-control benefits and alpha generation. As the hedge fund industry continues to evolve in this country, managers must continue to study and understand the nuances of the Canadian market: an understanding of sectors is key.

Andrew Marchese is Head of Canadian Equities and Portfolio Manager, Pyramis Global Advisors

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