2) Equity Market Neutral Hedge Funds At the other end of the spectrum is the equity market neutral hedge fund. The objective of this strategy is to generate positive returns through a portfolio of both long and short stock positions with net market exposure equal to zero. A typical market neutral fund will invest 100% of the fund’s assets in long equity investments while also short-selling 100% of the fund’s asset value in offsetting stocks. The long and short positions should be structured to ensure that the portfolio is neutral to the market, sector, industry and dollar amounts.
For example, consider a fund that purchases $5 million of ABC Bank stock while short-selling $5 million of XYZ Bank stock. As these two positions offset each other, the fund’s net exposure to financials and to the banking sub-sector is zero. Performance will be driven by the relative performance of these two stocks rather than the market. More precisely, if ABC Bank outperforms XYZ Bank, the fund will make money regardless of market direction, as shown in Figure 2.
The performance objective of a market neutral hedge fund is to provide a positive return in excess of cash (T-bills + 3%, for example) regardless of the performance of equity markets. As of July 31, 2008, the return of the Hedge Fund Research Inc. (HFRI) Equity Market Neutral Index was +2.4% year-to-date. Compared to the S&P 500’s return of -12.6% (in U.S. dollars), the results are favourable and suggest that market neutral strategies, on the whole, are doing what they’ve been designed to do in this period of market uncertainty. Over the longer term, the index has achieved positive absolute returns in each of the past 15 calendar years from 1993 to 2007.
3) Long-short Equity Hedge Funds Falling somewhere between the 130/30 fund and the market neutral hedge fund is the long-short equity hedge fund. Whereas both of the previous strategies have constraints around the amount of shorting and leverage that can be employed, long-short equity hedge funds tend to be less constrained, allowing the manager to determine the appropriate amount of leverage to be used given the market conditions (within certain guidelines set by the fund). The strategy will include both long and short equity positions but can have either a net-short or net-long bias, depending on the manager’s outlook for equity markets at that time.
Typical trading strategies employed by the long-short fund may include pairs trading (purchasing one security and selling another when their prices are not in line with their historical relationship); the use of futures, derivatives or exchange-traded funds to hedge stock market or sector exposure; event-driven strategies (such as merger arbitrage); and relative value trades (buying a cheap security and short-selling an overpriced security).
Given the latitude provided to a long-short equity hedge fund, the objective is to provide a high level of returns regardless of the direction of the stock market. As of July 31, 2008, the return of the HFRI Equity Hedge Index was -3.6% year-to-date. While the recent results are not stellar, they are favourable compared to the results of the S&P 500 Index over the same period. On a longer-term basis, the HFRI Equity Hedge Index has achieved positive absolute returns in 14 out of 15 calendar years from 1993 to 2007.
Implementation Considerations
As with any investment strategy, plan sponsors must complete due diligence prior to selecting a strategy or an investment manager. The answers to certain key questions will help determine the direction that a pension plan should take. What is the plan’s objective— to increase returns, to increase diversification or a combination of both? How does the addition of a specific strategy change the plan’s overall risk profile?
In evaluating each strategy, plan sponsors should recognize that the funding for a new mandate should come from a plan’s equity allocation, given that each strategy uses the equity markets. However, net market exposure should be a key driver in deciding if the mandate will be part of the plan’s equity allocation or an alternative investment. With long and short positions constructed to maintain 100% equity market exposure, 130/30 strategies are well-suited to be part of the equity allocation and could represent an alternative to long-only equity strategies. Equity market neutral funds and long-short equity hedge funds should have low correlation to general equity markets and therefore can be viewed as alternatives, along with other traditional diversifiers such as real estate and infrastructure.
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