In this article, Steve Johnstone, manager of the Janus Henderson Global Equity Market Neutral strategy, presents the case for why investors should consider an equity fund targeting positive absolute returns and low volatility, whatever the market backdrop.
- By historical measures equity valuations have been persistently high in the current market cycle, driven by extraordinarily accommodative monetary policy globally.
- Equity market neutral strategies are designed as a hedge against market factors, with the aim of improving risk-adjusted returns, while avoiding large losses and hopefully compounding returns for investors over time.
The past decade has seen a bull market of unprecedented duration, fortified by an extraordinary and sustained level of government and central bank support. As we reach the end of this ageing cycle, and with a raft of emergent risk factors – from ongoing Brexit negotiations and the theatre of the upcoming US presidential election to the Coronavirus – should investors be considering their options?
Bull markets that run long have a long way to fall
By historical measures, equity valuations have remained high so for a prolonged period. The longer a bull market runs, the greater potential there is for larger falls. Looking at the longest five US bull markets of the past century (see Exhibit 1), the average stock market fall in the subsequent 12 months is 19.2%.
Exhibit 1: Every bull market comes to an end
Source: FRED (US Federal Reserve Economic Data), S&P Dow Jones Indices.
The current bull market has been largely driven by extraordinary accommodative monetary policy globally; an era that is coming to an end. With so much entrenched uncertainty right now, we think that a market neutral absolute return strategy is a sensible route for investors to consider.
One of the core attractions of a global market neutral strategy is its limited correlation to both equities and other alternatives. Looking over the past market cycle, from 1 October 2007 to 31 December 2019, the correlation in performance between the HFRX – Equity Market Neutral Total Return Index and the world’s major equity markets was below 0.3, a level that we would consider low in absolute terms (see Exhibit 2):
Exhibit 2: Low correlation with major global equity indices
|HFRX – Equity Market Neutral Total Return Index Correlation|
|S&P 500 Index||0.24|
|MSCI Europe Index||0.15|
|MSCI Emerging Markets Index||0.18|
Source: Janus Henderson Investors. Period of analysis from 1 October 2007 to 31 December 2019 in USD. Past correlations are no guarantee of future correlations. It is not possible to invest directly in an index. Past performance is not a guide to future returns.
Why not just buy an index?
The low-cost passive / ETF industry has gained terrific momentum over the past few years. The low cost of borrowing for companies and the flood of money into the economy from QE has helped to boost asset prices. This world of ‘free money’ has been a halcyon period for passives, attracting investors because of their low cost, with few periods of significant drawdowns to undermine sentiment. ‘Buying the index’ has resulted in generous returns, because the economic and monetary environment has been very supportive. Investors have piled more and more money into the same stocks, creating a positive feedback loop for share prices.
But there are inherent risks to this strategy. Investments that have no basis in fundamentals are a potentially risky place to be when risk aversion takes hold, as we have seen in the wake of the recent coronavirus. In this environment, investors looking to sell their investments can struggle to find buyers, either leaving them holding intrinsically unattractive stocks, or being forced to sell at a steep discount.
The last few weeks of 2019 were a good example of what can happen when markets turn. The leading US equity market temporarily cracked under an accumulation of worries, including trade conflict with China, concern over the tightening policy stance of the US Federal Reserve and the US government shutdown. At that time, global equity markets were hit by a huge spike in volatility which culminated in a massive short-term sell-off in equities. Historically, these sudden equity market losses are not unusual, but many market participants had become complacent to the risks.
Looking at 2018 and 2019, the worst 10 months for equities saw total drawdowns of 9.9%. During these same 10 months, the HFRX EH Equity Market Neutral Total Return Index saw drawdowns of just 0.5% – truly diversified performance versus other asset classes.
How do equity market neutral strategies mitigate risk?
Equity market neutral strategies are designed as a hedge against market factors, with the aim of improving risk-adjusted returns, while avoiding large losses and hopefully compounding returns for investors over time. While they can invest in various ways, they commonly operate by taking long positions in well managed businesses with strong market positions or those with attractive prospects, while shorting those stocks that do not display the same positive characteristics, known as a ‘pairs-trade’ strategy. The aim is to deliver performance by capturing the spread between the two, with significantly lower volatility that equities over time (Exhibit 3).
Exhibit 3: Significantly lower volatility than equities
Source: Janus Henderson Investors. 12 month rolling volatility. Period of analysis from 1 March 2004 to 31 December 2019, in US dollars. Past performance is not a guide to future performance.
In a world where investors are increasingly looking for substantially differentiated investment ideas, equity market neutral strategies have a role to play. Both for those investors worried about the risks inherent in a long bull market, and those who do not wish to factor market timing into their long-term strategy. While performance is unlikely to match the eye-catching numbers of an equity bull market in full flow, sometimes slow and steady is a good choice.