Can equity market neutral strategies perform even when markets are really stressed? Here is the answer of Emmanuel Terraz, Global Head of Absolute Return & Quantitative Equity and Head of Equity Market Neutral
It is no secret that timing the markets is very difficult, if not impossible. In bull markets, investors rarely think about it; but every time prices crash, many wish they had done more to protect their portfolios. Some investors try to decorrelate their portfolio by looking for sources of returns that do not depend on broader markets. That type of returns comes within the scope of absolute return strategies, which are based on the objective of providing some degree of risk mitigation for portfolios.
Equity market neutral strategies aim not to be dependent on any particular type of market environment. Their objective is generating excess returns and making the portfolio as insensitive as possible to market fluctuations.
How do they do this?
There are different types of strategies that exist. At Candriam, we believe combining complementary strategies is key to delivering performance. As an example, index rebalancing strategies are more effective when there are significant levels of dispersion of returns in the markets. For our part, we have studies showing that relative value strategies typically perform well when the dispersion of returns is low. It means that when these two strategies are combined, they can offer effective diversification benefits and provide good risk-adjusted returns regardless of market direction. Combining complimentary approaches can also offer an answer to the question whether an equity market neutral strategy can produce gains in most market environments.
Utilised in portfolio comprising asset classes such as bonds, real estate and commodities, an equity market neutral strategy can stabilise the overall performance of a portfolio. As these strategies are less correlated with most traditional asset classes, they can also help reduce the portfolio's volatility and therefore its risks.
Candriam’s track record
At Candriam, we have been managing strategies of this type for almost 20 years. The investment process, which aims to protect portfolios from directional market trends, has proven its effectiveness during turbulent periods. Therefore, we have been able to sticking to our proven process: identifying opportunities and taking positions when the risk/return ratio is attractive.
Our investment process combines two complementary arbitrage strategies. First, arbitrage positions are taken on the main global indices such as S&P 500 or Euro Stoxx, so as to benefit from price fluctuations during their regular rebalancing. Indexes typically rebalance on a consistent schedule, but the timing can vary by provider. During this process indices add or/and remove securities and change the weights of existing index constituents. All this activity impacts share prices on the stock exchange. It means that in volatile periods, at the time of rebalancing of the largest indices the market exhibits even higher volatility.
Finally, we build arbitrage positions in the portfolio based on relative value strategies. The aim here is to exploit the relative price differences between two similar instruments, such as two stocks from the same industry.
Chart: Performance of Equity Market Neutral Strategy
Source: Bloomberg and Candriam as at March 2022
Quantitative & qualitative
When selecting the positions to include in our portfolios, the two complementary aspects of our process are particularly useful in these turbulent times. First, we use quantitative tools to identify investment opportunities. It is important to note that this method is independent of the news flow and volatility of the markets. Second, through the valuation process and the qualitative analysis we apply before taking a specific position, we are able to understand the key risk factors associated with each investment opportunity and how they may impact our portfolio. This process allows us to adjust the size of our positions and hedge them efficiently in the current market.
What about the competition?
We don’t have direct competitors, only indirect competitors that implement different absolute return strategies. Some long/short equity funds implement more “common” strategies, that can be very crowded in certain market conditions. The result? Disappointing performance of such funds, as we saw during the COVID market crisis in 2020.
Most long/short fund managers have significantly reduced their leverage in mid-March 2020 because of the rise in volatility in this period. This has had a drastic impact on many investors - the more funds transact the same trade, the worst is the impact on the price of the security in which they try to deal. The sheer transactional volume magnifies the effect on the price. As these transactions triggered a domino effect that led to stop-loss limits being reached in other funds, these also began to sell positions. As a result, many funds involved in transactions of this nature were severely affected and experienced significant fluctuations in their net asset value.
We believe that the strengths of Candriam's approach are our unique investment process mixing quantitative & qualitative approaches, and also the compatibility of our strategies with the strong rise in passive investing which has become a major market trend.