According to a current study eight out of ten market-neutral equity funds show a negative performance in the past year. The longest uptrend in stock market history of the US Blue Chip S&P 500 Index made it extremely tough for long/short fund managers to make money on the shorts, plus volatility declined by late summer 2018 to ever-lower levels. No wonder then that many long/short equity funds performed negatively in this market environment. Given the topicality of this issue, Hagen-Holger Apel focuses on the success factors of market-neutral equity strategies which have been a part of DNB’s core offering since 2010:
Success factor 1: Place a focus on a few sectors
Many investment companies rely on a broadinvestment universe. However, it is clear that a focus on individual sectorscan pay off. With the technology, media and telecommunications sectors, or TMTfor short, DNB Asset Management has concentrated on one area only. Greater volatility compared withother sectors, in particular in the technology sector, enable additional returnopportunities. A diligent bottom-up equity analysis in connection with strongerfluctuations in these sectors make it possible to generate excess returnsrelative to the benchmark (Alpha).
The strategy of the DNB Fund – TMT Absolute Return isnot based on pair trades within one sector. It is much more important toconsider the relative valuation of individual sectors and of the individualsecurities together. At the moment, it seems that high growth/high valuation isregarded with scepticism by many market players following years ofoutperformance, whilst value is returning to the investors’ radar againfollowing sustained underperformance. Quite apart from that though, there arelots of opportunities within the investment universe based on the relativevaluations. As a result, in 2018 the portfolio managers on shorts activelypursued securities from the semiconductor sector comparatively early which theyanalysed as clearly overvalued. They also held long positions in Ericsson andLenovo, which make a significant contribution to the positive annualperformance.
Success factor 2: The right stock selection
In addition to volatility, the correctstock selection helps to achieve excess returns. Via bottom-up stock pickers,the companies are viewed at micro level and, furthermore, value components tobe taken into consideration. “We are not, therefore, prepared to fund highmultiples of earnings or simply abide by promises. In otherwords: we do not buy thestories blind; instead, we challenge them. Here, we pay attention to the trackrecord of management and whether firms are actually generating profits,”explains Hagen-Holger Apel.
Success factor 3: Operating outside the mainstream
One of the core competences of a portfolio managershould include looking in precisely the locations where many others do not, andnot to act as the mainstream does. For example, graphics cards manufacturerNvidia was analysed in summer 2018 with the conclusion that the stock wasovervalued. “Based on this assessment, we included this security in our shortpositions – themassive decline in the price of the stock by more than 50% has paid off verywell for our portfolio,” according to Apel. When holding high convictionpositions, on either the long or short side of the portfolio, there must alwaysbe an appropriate residual portfolio. The principal concern of the portfoliomanagers here is tight control of the risk budget and the portfolio volatility.
Success factor 4: Short potential among overvaluedsecurities
Adopting an approach against the market may, however,also mean being positioned too early occasionally. Ericsson, for example, wasamong the least fancied stocks in the universe and initially lost some valueafter inclusion in our portfolio. Despite some criticisms by investors, theportfolio managers held on to the securities. In the meantime though Ericssonranked amongst the most profitable positions in the fund. Having said that, wedo not “fall in love” with equity positions: if a company does not evolve inline with our expectations, we will readily split from the position,” accordingto Apel. The key responsibility remains to avoid excessive losses andconsequently strict position management is necessary.
Even stronger performance of long/short strategy in2019 possible
Looking at the current year, what is expected to besustained volatility should favour the strategy outlined, in particular sincefor some overvalued securities sufficient potential for short engagements isanticipated. At the same time, technology stocks merit an encouraging rating inthe medium to long term – with higher profit forecasts and better margins than numerous othersectors such as industrials, banking or consumer discretionary. AlongsideGoogle parent company Alphabet and Oracle, Japanese firm Nintendo also ranksamongst the biggest long positions in the DNB Fund – TMT Absolute Return.Lenovo will also stay in the portfolio. The question remains which selectioncriteria investors looking for the right market-neutral equity fund should payparticular attention to. Gross exposure is extremely important as well asvolatility which should be between five and ten percent. It measures the sum ofthe long and short engagements and should be between 160 to 190 percent. Forthe higher the gross exposure, the more volatile and more costly a potentialimbalance.
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All information reflects the currentestimates of DNB Asset Management, which may change without notice. DNB AssetManagement provides no guarantee of the accuracy or completeness of theinformation. This information does not take into account the individualinvestment goals, personal financial situation or specific requirements of aninvestor. DNB Asset Management accepts no responsibility for losses frominvestments made on the basis of this information.