Navigating Choppy Markets
October has been unkind to equity investments. As I write, the ASX200 is down more than 8 per cent month to date, and most global indices show similar numbers. At a time like this, concepts that previously seemed theoretical become much more tangible, and investor focus naturally shifts from return to risk.
There are a few ideas worth discussing in this context, and in the weeks ahead we’ll likely publish a series of articles around risk and dealing with challenging markets. For this episode, I’ll use the recent market experience to illustrate one investment structure that can contribute greatly to investor peace of mind at a time like this. Specifically: a market neutral structure.
The smallest fund in the Montgomery stable – the Montgomery Alpha Plus Fund– is a market neutral fund, which means that it invests in roughly equal-sized portfolios of both long and short equity instruments. This structure is designed to avoid– as far as possible – equity market risk by having the market risk in the long and short portfolios effectively cancel each other out. The goal is for the returns from the fund to be independent of movements in equity markets generally, which is an attractive feature at times like these.
A little history
Before we get to the key insight, we should note that when we originally set up the Alpha Plus fund in 2016 and we didn’t design it as well as we could. In particular, it was established as an Australia-only fund with a quality overlay, which meant that it was inclined to hold higher-quality Australian companies in its long portfolio, and lower-quality companies in its short portfolio.
This approach has some intuitive appeal, and should provide for good performance over long stretches of time. However, the Australian market is very idiosyncratic: it has a large proportion of cyclical businesses in the materials and energy sectors which generally fall into the “low quality” category. The nature of cyclical businesses like these is that they sometimes enjoy periods of strong performance, and when that happens, having a structural “short” exposure to these types of businesses produces strong headwinds.
That is exactly what happened in the first two years of the life of the Alpha Plus Fund. The ASX materials sector, in particular, began a strong cyclical recovery in February 2016, and the Fund’s quality bias saw it shed 10 per cent of its net asset value during the first two years of its life. At some point it is reasonable to expect these cyclical headwinds to turn into cyclical tailwinds, but history suggests that these sorts of cycles can easily persist for as long as five years. That sort of timeframe presents a stern test of investor patience.
Recognising this, at the start of October 2018, we redesigned the Fund to provide a more consistent experience for investors. In particular, we extended the Fund’s mandate from Australia-only to include global equities, and we removed the overt quality overlay. The Fund will still prefer high-quality businesses to low-quality businesses but will do so in balanced way, and without large, permanent sectoral over/underweights. Also, a global universe allows it to be much more diversified. This should allow it to achieve similar long-term results, but with less of a “feast or famine” profile along the way.
With that out of the way, we come to the point of this article.
So what has happened in October?
Today the Montgomery Alpha Plus Fund invests in Australia, Hong Kong, Western Europe, Canada and the US. All of these equity markets have fallen sharply during October. However, at the time of writing, the Fund has reported a modest positive return for the month to date.
The point here is not that the return is positive – in any single month the Fund’s results will be largely driven by short-term noise, and it is only over much longer periods of time that we will properly see what the return profile looks like.
The point is that the return during October has been unrelated to what happened in the equity markets that the Fund operates in. The Fund has similar sized long and short exposures in each one of these markets, and this gives it real protection against market turbulence, be it global or regional turbulence, as well as providing natural currency hedging.
If the Fund is able to maintain this freedom from equity market risk and generate reasonable returns over the long term (and we will need to wait some time for confirmation of the return profile) it will provide investors with an excellent portfolio diversification opportunity.
Being exposed to equity markets is a very sensible risk/return proposition over long periods of time, but when equity markets fall hard – as they inevitably do from time to time – having part of your equity investments protected from the storm has obvious appeal.
This structure is not unique to Montgomery. There are many other market neutral funds available to Australian investors and operated by skilled managers. We find that not that many investors fully appreciate the merits of these types of investments. Probably more should.