Happy New Year!
The MarketTiming Conservative strategy has been ranked best ‘long only’ strategy for both the last one and two years in the global league table prepared by www.TimerTrac.com, the independent US auditor of market timer services.
Over three and four years the strategy is ranked second best and over five and six years, third best. As we’ve refined the strategy over the last nine years it’s clearly got better
MarketTiming’s share market strategies (especially our Conservative strategy) are designed to mitigate share market crashes that happen on average every three and a half years. Many of you already use our strategies for a portion of your share portfolio.
Our aim is to ride share booms and by avoiding the worst of busts to smooth the share market journey over a full bull-bear cycle. The following chart shows how one US market timing service (‘TimingIndicator.com Schannep Timing Indicator’) that’s operated since 2005 largely sidestepped the crash of 2008 thereby overtaking the S&P 500 stock index.
Figure 1. How a US market timer beat the S&P 500 index by mitigating the 2008 crash
This week I shall introduce you to some Australian hedge funds that have stayed out of share market busts and enjoyed strong capital gains. However, few investors know about them even though Australian hedge funds have attracted international attention for their stellar performance (see http://www.afr.com/markets/high-flying-australian-hedge-funds-attract-global-interest-20160811-gqqeaz). What I say is an update of my piece on June 26th 2017.
Hedge funds as their name suggests are meant to hedge downside risk so that one always wins and rarely loses. They provide a safety net by running long/short positions which means they bet on shares both rising and falling in price.
A hedge fund can take a short position by borrowing stocks from a shareowner for a small fee, selling the stocks for their full value and then buying them back at a lower price and pocketing the profit before returning them to the shareowner.
The purest form of hedge fund is a market neutral fund which aims to deliver superior returns by balancing bullish stock picks with bearish ones. In theory they are meant to largely eliminate market risk because if there is a general crash the stocks shorted should rise in value to offset the ones bought that fall in value. In practice that doesn’t always happen, yet market neutral funds that existed during the 2008 global financial crisis largely achieved that feat.
In Australia they included the Watermark Market Neutral Trust Fund, the Bennelong Kardinia Absolute Return Fund and Optimal Australia Absolute Trust each of which incurred minimal losses during the share market’s sharp fall in 2008. Overseas, American hedge funds such as Bluecrest AllBlue, Atlas Global Investments and Millennium Management weathered the storm well too as did British hedge funds such as Man AHL and Winton Capital Management.
In Australia overseas hedge funds can be accessed either directly through their local office (e.g. Man Investments Australia) or through their local distributors such as CAIS (e.g. Millennium, Bluecrest and Atlas), Macquarie Bank (e.g. Winton) or Credit Suisse (various funds including Mebane Faber’s Cambria Investment Management, but for own clients only).
Hedge funds normally have a minimum investment threshold anywhere between $100,000 and $500,000 which is too high for average investors though Watermark has offered a market neutral trust fund) through a listed investment company (ASX code: WMK) since June 2013.
Also most hedge funds are reserved for sophisticated investors with a high income (over $250k per year) or high wealth (over $2.5m in net assets). But fortunately some are open to other investors. That’s important because many hedge funds have been successful at notching up consistent gains regardless of stock market gyrations. This remarkable achievement gets scant attention even by the financial media.
Hedge funds charge high fees typically comprising an annual management fee of 2% of the net asset value of the fund plus an annual performance fee of 20% of the increase in net asset value, subject to a high-water mark. Their published results, however, are net of costs and fees.
As already mentioned the purest form of hedge fund is a market neutral fund which matches its long and short positions on shares. This means for every dollar it holds in shares it shorts another dollar in shares so that the net market exposure is zero.
Short selling involves the sale of a share that has been borrowed with a view to buying it back at a lower price.
You might ask, why take a position in the market that ostensibly cancels itself out? The reason is that those shares bought long are considered jewels (i.e. have growth potential) while those shorted are considered junk (i.e. have loss potential). If this assessment proves correct the fund not only wins on the upside with the good shares but also on the downside with the bad ones.
An example of a pure market neutral hedge fund is the Blue Sky Absolute Return Portfolio which actively eliminates market exposue by using hedging techniques. To quote Blue Sky, it “seeks to make a return regardless of whether markets are rising or falling. It does this by investing in a diverse range of assets with specialist managers while hedging out currency and equity risk to a long term target of nil.”
Since the strategy’s inception in November 2007 (the month the GFC bear market started), its return has been the same as the S&P/ASX 200m share index, but its price volatility has been only one third that of the index. That’s illustrated in the chart below.
Figure 2. Blue Sky Absolute Return Portfolio’s Risk/Return Matrix
This low volatility meant investors in the fund have sidestepped or profited from each crash and correction in the last ten years as can be seen in the next chart.
Figure 3. Blue Sky Absolute Return Fund’s Return versus S&P/ASX 200 Share Index
You might think that the fund has done poorly because the S&P/ASX 200 share index has finally overtaken it as shown in the chart above. But ask yourself this question – would you have preferred to take the Absolute fund’s route or the index’s path? The former was relatively smooth, while the latter was a roller coaster ride that would have tested your commitment to shares.
Also when the next crash comes would you prefer to have a fund that closely tracks the share index or one that bucks its trend? I’m not saying that the Absolute fund is a sure bet, but its durability during turbulent times is impressive. Note however, how it missed the market rallies of 2012, 2013 and 2017.
A stable mate of the Absolute fund is Blue Sky’s Real Returns Portfolio fund. It’s not a pure market neutral fund since it hedges only 50% of its share market exposure. As a result it did not do quite as well as the Absolute Return Portfolio fund during the 2008 GFC, but its subsequent performance has been outstanding as can be seen in the chart below.
Figure 4. Blue Sky’s Real Returns Portfolio’s Return versus S&P/ASX 200 Share Index
Furthermore, its risk (volatility) score was as good as the Absolute Portfolio, yet its annual return was significantly higher. This was possible because it took a stronger market exposure, yet somehow still managed to keep downside risk under control. Whether it would do that in another market crash only time will tell.
Figure 5. Blue Sky’s Real Returns Portfolio’s Risk/Return Matrix
Finally , Blue Sky offers a more risky product called its Dynamic Macro Portfolio. At first glance its performance chart is off-putting because its upper grey line is much more volatile than the blue line representing a buy and hold approach to its original share portfolio.
Figure 6. Blue Sky’s Dynamic Macro Portfolio’s Return versus its Original Portfolio’s Market Return
But closer inspection shows the Dynamic Macro strategy moves in the opposite direction to a passive share portfolio reflecting the market itself. This allows it to be combined with a passive indexed fund such as the SPDR S&P/ASX 200 share fund (ASX code STW) to produce a low volatility growth path as depicted by the green line in the middle of the chart.
The next chart shows how such a mix of 70% STW and 30% BSDM would have delivered a much better total return with much less price volatility that investing in STW alone.
Figure 7. Blue Sky’s Dynamic Macro Portfolio’s Risk/Return Matrix
I should add that Blue Sky’s Absolute Return and Real Return Portfolios are “fund of funds” (meaning it invests in other funds managers) with risk reducing overlays to manage market risk. By contrast Blue Sky’s Dynamic Macro Portfolio directly invests only in the liquid futures markets including FX, interest rates, commodities and equity indices such as S&P500 and FTSE, not directly in shares such as BHP and CBA.
The Affluence Investment Fund is another “fund of funds” than has managed to hedge downside risk without sacrificing upside growth during its short existence. It says it achieves this by “investing with 20 to 35 of the very best investment managers across all asset classes, predominantly through unlisted managed fund.” It will be interesting to see if it can sustain its amazing high return/low risk performance going forward.
Figure 7. Affluence Investment Fund’s Return versus S&P/ASX 200 Share Index
I have covered just a few wholesale hedge funds to illustrate how they work and have performed. Other funds are managed by Bennelong Kardinia, Watermark Fund Management, Optimal Fund Management, L1 Capital, Pengana Capital, Tribeca Investment Partners, Perpetual, Ellerston Capital, LHC Capital, KIS, Paragon, Totus Capital, Regal Funds Management, Janus Henderson, Auscap Asset Management, QATO Capital, Winton (via Macquarie) and MAN AHL.
The minimum investment per fund ranges from A$20,000 (Bennelong Kardinia and Pengana) to A$500,000 (Optimal and L1 Capital). Most require $100,000.
Long short hedge funds that are not strictly market neutral clearly take on market risk. If they use leverage and exotic derivatives to super-charge their performance, misjudge which shares to buy and short, have complex tax structures or lack sufficient liquidity they could result in significant losses.
Even pure market neutral funds are not immune to market risk. For instance QATO Capital’s Market Equity Long Short Fund got off to a flying start in August 2014 achieving a 28.8% return in just five months which won over investors. But in 2015 its total return was minus 1.7% and in 2016 it had a horror three months (Feb, Mar and Apr) losing almost a quarter of its value and ending that year with a net loss of 11.3%. During 2017 it racked up a further loss of 15.1% by November.
The tragedy of QATO is that its long positions sunk, while its short positions rose causing a double whammy setback. Holding these positions made sense on fundamental criteria, but the market perversely rewarded the junk and penalised the jewels in QATO’s portfolio. Research by Australian Funds Monitor shows QATO’s adverse results on returns and volatility are not shared by other Australian market neutral hedge funds.
For those who do not qualify as sophisticated investors there are retail products for hedging the share market.
Watermark has a listed investment company (ASX code WMK) operating a market neutral fund. This fund is distinct from Watermark’s market neutral trust which is a wholesale fund, but works on the same principles. Watermark describes its approach as follows:
“A market neutral fund allows investors to benefit from Watermark’s success in identifying “strong” companies to invest in and “weaker” companies to sell without being fully exposed to the volatility and risks of the share market. The investment portfolio of shares we favour is funded from the proceeds of selling ‘short’ the shares of companies we dislike.
“The ‘longs’ and ‘shorts’ are approximately of equal value, minimising exposure to general market movements… The fund will profit to the extent that the longs outperform the shorts, irrespective of the the performance from the underlying share market.” 
Like most market neutral funds, Watermark rates it performance against the Reserve Bank’s cash rate since it is not trying to beat the share market to which it has a net nil exposure. Nevertheless, notice that it sidestepped the share crash of 2008. Note also, that $100 invested in December 2006 grew to $361 by August 2017 net of fees. $100 invested in a S&P/ASX 200 accumulation index fund over the same period would have grown to just $171 (and less after fees). Again it shows how winning by not losing pays off.
Figure 8. Watermark Market Neutral Funds’ Return versus RBA Cash Rate Return
Bennelong Kardinia also offers both retail and wholesale hedge funds with a minimum investment of A$20,000. As can be seen from its chart below, it’s been successful in largely avoiding both market crashes and corrections since its strategy began in May 2006. It does not leverage, but like other hedge funds uses derivatives such as options, futures and warrants to short sell securities.
Figure 9. Bennelong Kardinia Absolute Return Fund’s Return versus ASX 300 Accumulation Index
Another retail hedge fund is Auscap Asset Management’s Long Short Australian Equities Fund which has been operating since December 2012. It’s a fundamental value driven conviction portfolio that takes long, short or neutral positions in Australian shares. It uses leverage to enhance performance, which of course also introduces additional risk. In its short life it has notched up an impressive performance soaring during the market correction of 2015/16. Its performance chart can be found at http://www.auscapam.com/auscap-fund/fund-outline/# Though open to anyone its minimum initial investment is steep at $100,000.
Another way for retail investors to hedge market risk is using two exchange traded funds managed by BetaShares. They are the Managed Risk Australian Share Fund (ASX code: AUST) which can be found at http://www.betashares.com.au/fund/managed-risk-australian-share-fund/ and the Managed Risk Global Share Fund (ASX code: WRLD) at http://www.betashares.com.au/fund/managed-risk-global-share-fund/
The first fund invests in 200 Australian shares and the second in 1500 global shares and a risk management handbrake is applied to each fund in accordance with its market’s volatility. Between 10% and 70% of the stock exposure may be neutralized depending on that volatility. This is done by selling equity index futures contracts (i.e. ASX SPI 200 futures) to offset the market risk of the share portfolio.
BetaShares uses Milliman’s Managed Risk Strategy (MMRS) to reduce its market exposure when share volatility rises. Milliman is a leading global risk manager. Here is a chart of Australia’s VIX index (also called the fear index) which tracks S&P/ASX 200 index option prices to gauge anticipated levels of near-term volatility in the Australian equity market.
Below is a chart comparing the BetaShares Managed Risk Australian Share Fund (AUST) in blue with the S&P/ASX 200 share fund index in red. Note how more stable the AUST fund is than the 200 shares in the market index. Note too that AUST did better than the share index during the correction of 2015/2016, but lagged the index thereafter.
Figure 11. BetaShares Managed Risk Aust Share Fund versus SPDR 200 Share Fund
Likewise here is a chart of the BetaShares Managed Risk Global Share Fund (WRLD) versus the SPDR World excluding Australian share fund (WXOZ). WRLD has kept up with WXOZ, but has done so with less downside risk. Both of the BetaShare funds don’t go back further than December 2015 when they were launched.
Figure 12. BetaShares Managed Risk Global Share Fund versus SPDR 200 Share Fund
The BetaShare funds besides being available to retail clients regardless of income or wealth have another advantage; their management fees are only 0.49% (AUST) and 0.54% (WRLD) which are a fraction of what the hedge funds charge. Furthermore if MarketTiming clients wanted to add an extra layer of safety to the AUST fund they could apply its Conservative trading strategy signals to it.
Finally, to monitor how Australian hedge funds work and perform there is no better source than Australian Funds Monitor. It charges a monthly subscription fee, but its website (https://www.fundmonitors.com/), weekly newsletter (firstname.lastname@example.org) and free trial (https://www.fundmonitors.com/subscription.php) give you gratis access to some of its latest fund research.