Ian Heslop of Old Mutual talks to Beth Brearley about his market neutral approach to portfolio management.
Q: The Old Mutual Global Equity Absolute Return (GEAR) fund has an impressive performance record over one year, up 10% against an average fall of 0.3% in the IMA Absolute Return sector. What do you attribute these returns to?
A: First, our focus is market neutrality. It is apparent there is some measure of beta in other people’s investments. This is great on the upside but difficult on the downside.
Second, we are very dynamic in the fund’s individual strategies. We questioned in 2011 the investment risk appetite and asked are investors being speculative or are they being defensive? It was very apparent in 2011 that if you got it wrong you underperformed. If you had value exposure then you got buried.
There was an intra equity rotation away from risky stocks, which are highly correlated with value. So last year, investors were behaving rationally, rotating away from risk to safety.
But what lead to our performance was that we spotted this early, and rotated in February, so we were prepared for the dislocation in the spring and summer. We saw positive returns broadly across all sectors – we didn’t just get one thing right.
The difference with our fund is it is not equity replacement, it is absolute return market neutral. All of the strategies in the portfolio are market neutral.
This means returns are uncorrelated with any asset class; there is a -0.1 equity correlation through the life of the fund. So as we are not exposed to equity returns and we are not exposed to market volatility.
There have been significant changes to volatility in the recent period, but we were not exposed to that. We target volatility of 6% and below and the volatility is currently 4.7% for the life of the fund.
Q: You mentioned individual strategies within the fund. What is the investment policy of GEAR?
A: The fund is systematic and process driven. There are five strategies we use which are independent of each other.
The first strategy is ’dynamic valuation’. We use basic valuations and look at balance sheet strength to find uncorrelated returns, as standard valuation metrics can be very correlated.
Next we look at market dynamics. These are technical signals and are price driven. We look at trend signals and reverse signals.
The third strategy is ’sustainable growth’. This is not a stylistic bet on growth, but looking at mis-priced growth companies, for example if a company is attempting to over-deliver on earnings.
The fourth strategy is ’analyst sentiment’. We look at analyst information on any changes in forecast earnings, and how this is incorporated in the stock prices, and how this can be exploited.
Lastly, we research company management to see if it is in line with investors’ interests. We prefer organically grown companies which are efficiently using their capital.
We allocate capital to each strategy in conjunction with a proprietary risk model which grades the stocks. So we have a constrain on risk, but also on sectors, countries, regions and indices.
We have a mechanistic process to build the best portfolio using these inputs. However, we still have a huge ability to see into the strategies. This is glass box investing, not black box investing. The process is rigorous and systematic, but it has complete visibility. (Q&A continues below)
Q: Where have you been investing more recently?
A: We were rotating away from risk early last year but since August, particularly in December and January, it has been more appropriate to reallocate back into risk. People are selling down and quality stocks are expensive while value stocks are attractive.
We predicted that would be the case and did it early. We have moved into more speculative investments and reduced exposure to quality stocks. From a sector perspective, we have moved long the consumer discretionary space.
We were 3% short at the end of November and are now 4.5% long. We built up this position quickly, across countries.
We are 5% short financials, particularly in Europe, although this is under constant surveillance. They are not good quality but they are good value. In all likelihood we will take on more positions.
We may move to a more neutral stance, but not necessarily in the short term.
Q: What is the target turnover of the fund?
A: We turn over 8% of the fund per week and always have done.
Sometimes we do more to reset the portfolio. For example, we don’t want the portfolio to have a gross exposure of 220% or 180% so we normally reset it to 200%. If the market is up or down this means we have to do a lot of trading.
We are able to do this as we remove the less liquid stocks from our investment universe before we start trading, and we don’t have large positions – we have 420 holdings and they are 60 or 70 basis points on average.
The fund’s net exposure is also set to zero every time we trade.
Q: Are there any areas the fund does not invest in?
A: No, as we can find mis-pricing in most areas. But we are very hair-shirt about liquidity as we don’t want positions in very illiquid areas. Of the MSCI World DM index we remove the bottom 3,000 stocks.
Q: What is your outlook for the remainder of 2012?
A: In likelihood it will remain a macro market for a period of time. Correlation rose significantly into the year end, although it is falling a little.
Stocks are being driven by external macro factors not underlying fundamentals, which will continue.
Ian Heslop is the manager of the Old Mutual Global Equity Absolute Return fund.