The recent Lehman anniversary had market commentators everywhere asking how far away the next crash might be, leading to sleepless nights for investors of all stripes. There are however proven strategies available for these troubled times.
Back then, like now, Australian investors were captive to events from distant shores. And now, despite our triple-A credit rating, our 26 years without a recession, our ever-burgeoning $3 trillion dollar superannuation industry, we cannot escape the impacts of global macro-economic and geo-political events.
As for events of our own making, the property market is looking a little long in the tooth, credit from banks is not as plentiful, business costs are rising and, of course, the unfolding US-China trade war adds to our uncertainties.
Equity market neutral
In such an environment the objective is to remove the ‘known unknown’ – that is, what the market is going to do in the next year. Neutralise it using equity market neutral (EMN).
EMN can offer a safer alternative to the traditional balanced account of some cash, some bonds, and some stocks. Because if stocks fall significantly cash and bonds are not going to save you.
As we experienced in the GFC, even the brilliance of Modern Portfolio Theory – the brainchild of Nobel Prize winning economist, Harry Markowitz – could not withstand systemic shock. Indeed, there is no doubt that modern portfolio construction collapsed in the GFC.
The origins of EMN
Australian Alfred Winslow Jones can not only be credited for creating the first hedge fund back in 1949, but, arguably, the equity market neutral strategy with his first ‘long/short’ play. As his firm has written, each technique was considered risky and highly speculative, but when properly combined together would result in a conservative portfolio.
Jones derided his own ability to time the market, but he did believe in himself as a good stock picker, and 70 years on, Australia is blessed with a dozen or so practitioners who are similarly skilled.
Without wanting to embarrass them, this list includes people such as Regal Funds Management’s Phil King and Richard Fish from Bennelong, who have over the years delivered strong double-digit annual returns for investors.
There are some who dismiss equity market neutral as an investment strategy, critical of its low-ish returns. I simply say that EMN is about capital preservation, with a little more. Eurekahedge’s Equity Market Neutral Fund Index shows an annualized return of 5.21% since 2000. Its best year was 2000 with a return of 12.98%, while its worst was in the maelstrom of 2008 with a loss of just 0.03%.
So, when putting a portfolio together, I advocate the involvement of a number of skilled practitioners to deliver an intelligently designed equity market neutral strategy that is ‘all weather’ and agnostic to whichever way the market is going.
Using EMN in a strategy
You can think of EMN as a stabilizer providing the comfort of wealth preservation. In contrast, you can think of managed futures, which we wrote about in this wire, as being a driver of wealth generation.
In a nutshell, equity market neutral will keep you rich, while managed futures will make you rich, which is why the combination is already used widely across many endowments, foundations, family offices, and high net worth individuals' portfolios.
Combined, these are the strategies for our ‘new normal’ times.
Why would I pay a whole lot of fees just to generate neutral returns? If I just bought bonds for safety and some equities for growth, or ETF's for increasing diversity, reinvest the dividends in more ETF's, then I would do better and have a margin for safety in preserving my capital, would I not? Or am I misunderstanding your strategy and confusing it with marketing spin?