It can be difficult to find real alpha opportunities, which are based on consistently harvestable mispricings rather than a manager’s hard-to-replicate intuition. Certainly, the pages of the financial press are littered with tales of hedge fund managers whose hot hands have now gone cold.
But there does seem to be some method — and returns — in the event-driven space. “The value proposition of event-driven is a powerful one for those who are interested in moving along the efficient frontier, in that it offers the potential for alpha as well as being lower correlated with other asset classes,” said Arvind Navaratnam, a portfolio manager at Fidelity Investments, during a session at the 2017 Global Investment Conference in Banff, Alta. in March.
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In particular, he pointed to “attempts to take advantage of corporate actions, such as spinoffs, companies going through bankruptcy processes and other types of special situations.” Often, these types of events bring forced selling pressure, limited research coverage and other market inefficiencies that a disciplined, patient and opportunistic investor can take advantage of, says Navaratnam.
One stream of opportunities comes from the index-following bias of asset managers, which often overrides fundamental research. When indices are reconstituted, some assets can be had cheaply.
“The key thing is that there is a human behaviour driving the potential for mispricing behind all of this,” said Navaratnam. “Over $2 trillion today is indexed to the S&P 500, and so when Facebook was added to the S&P 500 a couple of years ago, $2 trillion was forced to buy Facebook without regard for the intrinsic value of that business and, similarly, when a business is removed from an index such as the S&P 500 without regard for the intrinsic value of the business.”
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Hedge fund managers often short stocks, which is a negatively asymmetric payoff because they can only double the money if they’re right but lose multiples of money if they’re wrong. It’s a bet Navaratnam refuses to take. Instead, he said, “we focus only on those types of corporate actions where there’s forced selling pressure. What we found is that these corporate actions offer the potential to dramatically outperform the market over long periods of time.”
He noted that companies that are subject to corporate actions, such as spinoffs, “behave very differently from the rest of the market, to the tune of the alpha stream being about one-fifth as correlated as other funds.”
Spinoffs have another characteristic beyond forced selling and it’s one that can provide insight on mispricing or rather, investors’ low expectations, noted Navaratnam. As an example, he cited the spinoff of Phillips 66 from ConocoPhillips Co. in 2012.
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“What’s interesting about spinoffs is that there’s this forced selling pressure. Also, in the case of ConocoPhillips, you have entrepreneurs who were part of a division of Conoco that could go after cost-cutting opportunities and growth opportunities that they couldn’t before because they are driving the shift.”
At the same time, Navaratnam minimized the downside stemming from the intervention of other market actors. “Investors can’t take the risk that the company announces it’s going to be spun off and then private equity buys it out,” he said. “Rather, investors need to get involved post-event — it’s less risky and offers meaningful outperformance.”
This article was originally published on Benefits Canada’s companion site, Canadian Investment Review.