Much of the confusion about what an absolute-return portfolio is arises from the rather cavalier way that some of these funds are labeled. Many funds are advertised as absolute-return plays simply because of their low correlations to market benchmarks. There's more to an absolute-return strategy than low index correlations, however. The goal of an absolute-return portfolio is to win consistent positive returns regardless of the performance of a market benchmark. Return targets may be set as a specific value or as a margin over inflation. A typical hurdle set for institutional portfolios is 300 to 500 basis points over a three-month LIBOR (London Interbank Offered Rate).
In the strictest sense, absolute-return strategies are not market dependent. Forsaking beta for alpha, these funds are inherently non-directional, providing risk comparable to that of an investment-grade fixed-income play with returns on par with those of a conservative equity portfolio.
Absolute-return portfolios are often mischaracterized as hedge funds. Hedge strategies, however, include a number of discrete and diverse plays. These strategies can be used to balance the risk of an investor's equity or fixed income exposures. Combined, they can create an absolute-return portfolio.
Unfortunately, it isn't easy finding a true absolute-return portfolio. There isn't a dedicated landing spot for them in the fund classification schemes of analytical outfits such as Morningstar and Lipper. Morningstar recently added an “alternative” bucket to its fund universe into which portfolios following hedge strategies such as “long-short,” “currency,” “specialty precious metals” and “bear market” are dumped. The category within spitting distance of the absolute-return definition is “long-short” which, counting all the multiple share classes, can be applied to hundreds of portfolios.
“Long-short,” though, is a bit of a misnomer itself. Long-short equity, as we'll see, is but one of the many tactics employed within absolute-returns portfolios. Morningstar's classification, however, includes an eclectic mix of portfolios following decidedly different strategies. Alongside long-short portfolios, for example, are such diverse category mates as market-neutral, arbitrage and option income funds.
Lipper, for its part, has added four separate categories for hedge strategies, including long-short equity, commodities, equity market-neutral and option arbitrage. Breaking equity strategies into two distinct categories — market-neutral and long-short — is appropriate, says Lipper senior research analyst Bill Sickles, because funds of each type “are a breed by themselves.” And since long-short funds make directional bets, says Sickles, “They're going net long or net short. They're not market-neutral.”
So, what are the components of an absolute-return portfolio, and how have they fared as asset values melted in 2008? The 10 largest funds in Morningstar's long-short classification represent an array of hedge strategies that, once combined, can be analyzed as a $20 billion absolute-return proxy.
Long-short managers typically attempt to reduce volatility and potentially increase returns by overlaying short stock positions on a long equity portfolio. The footprint of a long-short portfolio is a positive beta versus the equity benchmark. Short positions reduce an unlevered long portfolio's beta below 1.00, while a 120/20 or 130/30 management style uses the proceeds of the short sales to bolster the long side enough that a 1.00 beta exposure can be maintained.
Among Morningstar's 10 largest long-short portfolios are the Hussman Strategic Growth Fund (HSGFX) and the Diamond Hill Long-Short Fund (DIAMX) portfolios. Reducing equity market beta minimized — but did not negate — losses, this year. Long-short alone wasn't the path to absolute returns in 2008.
A market-neutral portfolio aims to isolate stocks' pure returns. A common play pits one stock against another from the same industry group. Buying one auto manufacturer while simultaneously selling short a rival, for example, permits a savvy manager to exploit a dominant outfit's competitive advantages for profit. The strategy is a money maker as long as the stock of the purchased company rises — or falls less — than the shares of company sold short, regardless of general market conditions.
The typical market-neutral portfolio is also cash-neutral — that is, the dollar value of its long positions equals that of the short side; but that alone doesn't insulate the portfolio from systematic (beta) risk. To be truly market-neutral, the portfolio must be comprised of positions matched to yield a forecasted net beta of zero. Any residual beta tail can be hedged away with index derivatives.
Two market-neutral portfolios populate Morningstar's top 10: the JPMorgan Multi-Cap Market Neutral Fund (OGNAX) and the Highbridge Strategic Market Neutral Fund (HSKAX). These portfolios produced wildly disparate results in 2008. OGNAX's performance was relatively good, but HSKAX's was the best on the roster. The Highbridge portfolio, in fact, was the only top 10 fund that met the two key criteria of an absolute return: a fixed-income-like volatility and a return that is 3 percent to 5 percent better than three-month LIBOR.
Hedged equity funds reduce beta by using derivatives rather than shorting individual stocks. The Gateway Fund (GATEX), for example, dampens the risk of holding a large-cap equity portfolio by selling index calls. Some of the premium collected is rolled into put purchases, creating a “collar” on the risk in a portion of the portfolio.
A net long-equity portfolio is also at the core of the Calamos Market Neutral Income Fund (CVSIX), but the portfolio's periphery combines convertible bond arbitrage and covered call writing to varying degrees depending upon market conditions. The arbitrage strategy entails buying convertible securities and selling short their underlying stocks to generate income and reduce market exposure. This also generates income with calls written against the stock held in portfolio. Both funds maintained high correlations to the equity market, which accounts for their less-than-stellar results in 2008.
Absolute-return strategies, as defined, aren't monolithic. They're integrated amalgams of some or all of the investment tactics examined here. It's therefore natural for an absolute-return manager to employ a fund-of-funds approach to diversify the sources of returns. Two funds in the top 10 take this tack. The GMO Alpha Only III Fund (GGHEX) relies upon internal management by holding other portfolios in the GMO family in addition to, at last look, a net-short position in the U.S. dollar. Its net exposure is 49 percent long stocks.
The Absolute Strategies Fund (ASFAX) relies upon several outside subadvisors to supply its universe of component returns. ASFAX's allocation scheme, however, maintains a significantly higher correlation to the overall market, which explains its poorer performance.
Merger Or Risk Arbitrage
Managers of arbitrage portfolios, such as the Merger Fund (MERFX), speculate on the timing of mergers and acquisitions. In anticipation of a deal closing, they will purchase a target company's stock and hedge it with a short sale of the acquirer's shares. The acquiring company's offer usually exceeds the target's current market price. A discount in the stock's market value tends to persist, reflecting the risk that the deal may not close. The fund, once long the deal, looks for the discount to shrink as the closing date approaches.
While merger arbitrage returns are largely uncorrelated to the overall movement of the stock market, a general decline can delay deals or scotch them entirely. That risk may be managed with short positions in index derivatives. A wholesale economic slowdown sharply reduces deal flow, however. That's a risk that can't be hedged away.
Historically, commodities are negatively correlated to equities, though there are times when futures and stocks move in lockstep. Short positions in futures, however, can be initiated with as much ease as long positions, so active managers have greater flexibility to capitalize on bear movements in commodities.
The Rydex Managed Futures Strategy Fund (RYMTX) tracks the performance of the S&P Diversified Trends Indicator, a long-short benchmark comprised of two-dozen diversified futures. Longs and shorts are established (or reversed) as the current price of each future rises (or falls) through its moving average. The portfolio also earns a cash return received from margin deposits held in money market instruments.
The Final Tally
The strategies employed by Morningstar's 10 largest long-short funds aren't exhaustive. Smaller portfolios in the category may pursue arbitrage in other quarters such as options or fixed income securities. Still, we can glean some insights about absolute-return strategies from the $20 billion invest in the category.
Only three portfolios, representing 26 percent of invested capital, managed to earn a positive return in 2008. The sole fund (Highbridge) that cleared the strategy's volatility and return hurdles makes up just 8 percent of the money at work in long-short portfolios. HSKAX earned an alpha of 0.44 for the year, meaning its return was 44 percentage points better than the level predicted by its beta.
It's easy to see why these three portfolios made money: They weren't correlated to the equity market. The asset-weighted beta for the trio is zero with an SPX correlation of -0.7 percent.
The story was equally clear for the category's laggards: The worst three performers earned a market-weighted 0.27 beta on a 43.6 percent correlation to SPX. Unfortunately, that's where the majority of the money is invested. Fully 53 percent of our sample's capital is invested in the three bottommost funds. Even with this underperformance, the funds collectively fared better than the overall equity market. The asset-weighted return for the category is -11.3 percent versus a 37.7 percent loss for SPX.
Nobody, however, should consider buying these funds in the hope of merely obtaining relative returns. That's the objective of more pedestrian money managers. No, in times like these, you and your clients need to do better. Absolutely better.
MORNINGSTAR'S 10 LARGEST “LONG-SHORT” FUNDS
Ranked by Risk-Adjusted Returns
|FUND/INDEX||Assets Ticker||Return ($mm)||YTD Volatility (%)||Annual Sharpe (%)||Mod Beta Ratio||SPX vs SPX||Correlation vs LBAGG (%)||(%)|
|Highbridge Strat Mkt Neu||HSKAX||1,562||8.5||4.1||1.71||0.01||5.1||5.1|
|Rydex Mgd Futures||RYNTX||1,044||8.9||12.8||0.58||-0.10||-31.8||2.3|
|GMO Alpha Only III||GGHEX||2,687||2.8||13.9||0.09||0.01||4.1||-4.6|
|JPMorgan Multi Mkt Neu||OGNAX||876||-2.5||4.7||0.00||0.01||10.3||14.6|
|Calamos Mkt Neu Inc||CVSTX||1,327||-15.6||13.4||-0.02||0.31||93.8||-30.9|
|Hussman Strat Growth||HSGFX||3,715||-22.7||24.6||-0.06||0.28||46.5||-3.0|
|Diamond Hill Long/Short||DIAMX||2,327||-23.6||29.4||-0.07||0.70||95.7||-21.4|
|S&P 500 Index||SPX||—||-37.7||40.2||-0.97||—||—||-25.3|
|Lehman Agg Bond Index||LBAGG||—||1.4||6.0||-0.01||-0.04||-25.3||—|
|Year-to-date results through November 28, 2008 based upon total returns, except for benchmarks.||Source: Morningstar, Commodity Systems, Inc., Brad Zigler|