The long and short of good returns

Despite a growing argument in favour of low-cost, index-tracking, passive investment, Jeremy Hall at Cartesian says stockpicking is still the best way to get above-average fund performance.

Britain’s biggest new investment fund was launched last week on a drizzly south London high street. There were no wall-size Bloomberg screens and no fancy corporate atrium. But in the mundane surroundings of a civil service office, the National Employment Savings Trust (Nest) was unveiled – and officials reckon it will grow towards £100 billion in size.

The money, made up of monthly contributions from workers saving for their retirement from 2012 onwards, will be managed almost entirely passively.

Nest reckons that low-to-middle income households (who will be its main customers) want two things when it comes to managing money. They can’t stomach absolute losses, and they don’t like volatility. Inevitably, therefore, the fund will be invested in gilts or gilt-like instruments, with perhaps a small amount in equity. They haven’t fully explained quite how they are going to avoid absolute losses, but they’re working on it. (article continues below)

There appears to be a growing intellectual argument in favour of low-cost, index-tracking, passive investing. At the launch, fronted by pensions minister Steve Webb, there was an explicit acceptance that, at a cost of 50 basis points per year, passive investing is both cheaper and better than using active managers. Academic research – such as that by Princeton’s Burton Malkiel, who I’ve previously interviewed for this column – is convincing: half a century of data tells you that putting your cash into an index fund is a no-brainer.

Interestingly, research from the investment banks (who after all make lots more money from active than from passive fund managers) suggests that indexing may be the way to go. Over the past year, stocks in the S&P 500 have become extraordinarily correlated. Measures such as 50-day average correlation are at their highest level ever. The conclusion is that the market has become perfect for indexers, not stockpickers.

Except that’s a load of old tosh, according to Jeremy Hall, the manager of the Ignis Cartesian Enhanced Alpha fund. “Correlation is the buzzword of the moment,” he says. “But all it tells you is that a lot of active fund managers are hugging their benchmarks.” In reality, says Hall, the divergence in returns between the best and worst performers in each sector is as wide as it has ever been. “What you have to do is roll up your sleeves and get your stockpicking hands dirty,” he says.

”What we are looking for are companies which have growth drivers even if there isn’t a wider growth environment”

During a long conversation, Hall doesn’t proffer a single macro view. He doesn’t pretend to know any more than the next economist/fund manager about the direction of the global economy, which he says is probably plagued by more “noise” than ever. “Only one of the 35 top economists got the UK GDP figure right. What does that tell you? My feeling is that the market will do what the market does. My job is just to find good companies to own, and bad companies to short.”

Enhanced Alpha is not an absolute return fund, nor a 130/30 fund. It’s just a “bog standard” Ucits III fund, domiciled in Dublin and run by a team at Cartesian who see their job as getting better than average returns with lower than average risk.

So far – the fund was launched in November 2007 – the approach appears to be working. It’s up 36% over the past year, compared with 16.5% for the average fund in the UK All Companies sector, but with lower volatility than its peers.

It hasn’t been plain sailing, though. Hall acknowledges a rough patch in 2009, when he held on to his shorts when he should have dropped them. “Quarter two 2009 was a terrible time to be shorting. The rising tide was lifting all boats.”

Since then, however, Hall has enjoyed a terrific run, in part by focusing on smaller and mid-cap stocks where he feels his long/short approach can make the most difference.

Two small oil exploration companies have contributed ­considerably to his performance. But this isn’t a story about lucky strikes. When it comes to oil, Hall will only buy companies that have real discoveries and real assets.

Rockhopper, for example. Rockhopper struck oil in the North Falkland Basin in May and its share price has quad­rupled. Hall bought at 82p, and it now trades at about 325p. “It’s amazing how some Falkland E&P [exploration and production] companies are trading at fancy price levels without having discovered anything. We looked at Rockhopper very, very closely. As you de-risk a discovery [checking the oilfield size] the asset value of that discovery improves. The market wasn’t correctly pricing it.”

He also refers to Nautical Petroleum, a North Sea explorer. It has found one of the largest fields in recent times and has seen its share price surge to 340p. “We bought at between 120p and 140p. The stock was held back as it needed to raise financing to expand. We’re still in there as we reckon there is another 30% upside in the value of the already discovered assets.”

Both oil stocks, he says, are good examples of non-correlated special situation stocks. But this isn’t a gung-ho fund full of special situations only. One of Hall’s biggest holdings is AstraZeneca, which he bought when its price/earnings ratio was close to its yield. “We don’t rule out big companies.”

Among the mid caps he likes Britvic, which he describes as well-financed and well-managed. “But I won’t say I’ve bought it for its international or emerging markets exposure. How many times have you heard that from other managers? It’s such an over-used phrase. What we are looking for are companies which have growth drivers even if there isn’t a wider growth environment.”

He then mentions another holding, SuperGroup, which is behind the wildly successful clothing brand, SuperDry. It is growing rapidly despite a dreadful background for UK retail.

But the market is also ripe for shorting, he says. A lot of companies recovered in 2009 and into 2010 but will have a harsher spotlight thrown on them. He shorted Connaught as its share price collapsed 95%. But he didn’t do it because he felt it would be a victim of government spending cuts. It was more that it looked weak on other metrics such as “aggressive accounting” and poor cash conversion.

“I think 2011 is going to be a great environment for both long investing and short investing,” Hall predicts. “The more people who get caught up in the macro noise – which is where everyone is right now – the more I’ll be able to find both good and bad stocks that have been overlooked.”