Do 1980s' timing strategies still work?: "definitely." (short-selling and market-neutral fund) (Pension Fund Management )
At Alcoa, we have both a short-seller fund and a market-neutral fund in our portfolio because we think they're good methods of increasing diversification and returns. The short-seller fund is managed by eight short-seller managers, and its performance is negatively correlated with the S&P 500. The market-neutral fund is managed by nine different investment managers and is called market-neutral because its performance should be relatively neutral or uncorrelated with the performance of the S&P 500.
Our short-seller fund is designed to reduce the overall volatility in the portfolio through its negative correlations with the S&P 500. In addition to this fund's diversifying characteristics, it has, at times, shown surprisingly good returns, although not so much over the last few years. Thus, it can enhance portfolio return while giving downside protection, unlike traditional hedging vehicles like put options.
An interesting component of the performance is the short-sellers' rebate. The rebate is the share of the money earned by the managers on the proceeds from the sale of the stock that's been shorted. It works like this: The short-seller identifies the stock that's overpriced relative to its value and borrows the stock from a broker. He then sells the borrowed stock through the same broker,and the proceeds of the short sale earn interest at a broker loan rate, which is currently approximately 5 percent. The short-seller receives about 80 percent of the 5 percent, or 4 percent annualized, as a rebate, which is normally not given to small investors. This rebate helps bolster a short-seller's returns, even in rising markets.
AN UNCROWDED MARKET
Another attraction of short-selling is that relatively few dollars are invested in it. Our managers estimate that the total across the United States is probably less than $30 billion, and a significant proportion of that is the short positions of hedge funds. If you look purely at short-sellers, the market is only about $1 billion to $1.5 billion, compared to $3 billion a few years ago. Therefore, it should be much easier for short-sellers to find overpriced candidates for short sales than it is for long buyers to find cheap candidates for purchase.
These trusts have some desirable risk/return properties, too. Compare a portfolio with a standard asset allocation of 60 percent S&P 500, 35 percent bonds and 5 percent cash to a portfolio of 50 percent S&P 500, 25 percent bonds, 10 percent equity-partnership fund (a hedge fund), 5 percent short-sellers' fund, 5 percent market-neutral and 5 percent cash. The overall rate of return increases from 13.5 percent in the standard asset allocation to 14.6 percent in the diversified allocation. More importantly, risk is reduced from 8.1 percent to 6.8 percent. Therefore, we expect to earn 29 percent more for each unit of risk borne in the diversified portfolio.
Some people view short-selling as un-American because they say you're selling short Corporate America. In fact, some short-sellers even have a Wizard of Oz complex. They're behind a curtain because they don't want to be known as short-sellers. But it's an investment vehicle like any other. Diversification is in our plan participants' best interests, and these investments protect us from downside risk. Also, we don't have a great deal of money invested in it, and even our fund managers don't recommend that we put more than 5 percent of our money in our short-seller fund.
The market-neutral fund seeks an average annual rate of return equal to the Treasury-bill yield plus 5 percent, net of all fees and with no negative years. The trust is designed to do this regardless of the direction of the underlying markets -- hence the designation market-neutral. The six major strategies the fund uses are as follows.
* Japanese warrant arbitrage -- This primarily involves buying a Japanese warrant that trades cheaply and simultaneously selling short the underlying Japanese stock.
* Convertible arbitrage -- This is buying a domestic convertible bond long and selling the underlying stock short.
* Collateralized mortgage obligations arbitrage -- Here you purchase both CMO residuals and principal-only pieces in correct proportions, so that the interest-rate sensitivities of these two pieces offset each other, while still maintaining a high yield in the combined position.
* Options arbitrage -- This means identifying mispriced options and then constructing market-neutral positions with related options to extract profits from the mispricing.
* Merger arbitrage -- This is where you arbitrage various securities of companies that are involved in mergers and acquisitions.
* Plain-vanilla market-neutral strategy -- This is the long/short equity basket, meaning you buy a basket of cheap stocks, while simultaneously selling short equal amounts of over-priced stocks.
Over the last few years, the market's started to lean much more to the arbitrage strategies. That's because the short positions in long/short equity baskets have been pounded because of momentum investing and all the money flowing into mutual funds, which invest in small capital stocks that are popular shorting targets. Since it's becoming very difficult to short stocks effectively, our managers have been moving away from long/short strategies, and their returns on that trust have been improving significantly ever since. Only one of our nine managers is a long/short manager.
A NEW BALLGAME
Investment banks have been doing these kinds of arbitrages for years with their own equity capital, but these strategies are relatively new to institutions. To illustrate, let's take the plain-vanilla long/short equity basket, a good example of the partially offsetting nature of the cash flows in these strategies. Given an evaluation methodology for ranking stocks, an investor can earn market-neutral rates of return by buying undervalued stocks and simultaneously selling short the overvalued stocks. Thus, the return should be similar, whether the market rises or falls.
Here's how this kind of investment works. For starters, you search for both good and bad values. For illustration purposes, let's use the Value Line rankingsystem. First, the top 100-ranked stocks are purchased and the bottom 100-ranked stocks are sold short. For example, you buy the top 100 Value-Line names for $300,000 per name and you sell short the bottom 100 names in an equal dollar amount for $300,000 per name. With this method, you collateralize the shortsales with the long, thus requiring a net investment of $30 million. If both the longs and the shorts rise, you'll make money in a rising market as long as thepurchases outperform the short sales. If both longs and shorts decline in value, you'll still make money, as long as the purchases decline by less than the amount of short sales -- hence the term market-neutral.
In this example, stocks can be rotated in and out of the long and short baskets as they become fairly priced. In addition, you can enhance the fund's neutral characteristics by equally weighing longs and shorts within finite industry groups, like energy stocks. In all market-neutral strategies, managers constantly search for a mispricing discrepancy or market discontinuity that they can exploit. This pricing discontinuity lasts only a few minutes or hours before other investors recognize it and the profit opportunity disappears.
Short-selling and market-neutral strategies can be very rewarding to plan beneficiaries if the plan sponsor is willing to take the time and effort necessary to become involved and understand today's complex capital markets. Commingled, multi-manager group trusts allow us to inexpensively exercise some exciting, low-risk, high-return investment strategies as part of our traditional investment plan. Over the long term, we should get a handsome return as well as great diversification.
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|Date:||Jan 1, 1994|
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