Institutional Investor's Alpha Magazine - March 2009 - (Page 51) forecast future earnings. They talk to management, competitors and the supply and distribution channels and dig up whatever else they can from Wall Street or other sources. Ultimately, it comes down to a three-part assessment. “Some of the research is hard numbers, some is qualitative, and then there’s an element of judgment,” Klein says. Sequence’s long-short portfolio typically includes 65 to 70 stocks, and its average position size is just over 1 percent of holdings. At least one third of its trades play out over 12 to 18 months, so portfolio turnover is relatively low. The firm’s strategy falls at the low end of the long-short spectrum, where net market exposure can run anywhere from zero to 80 percent, according to Antonio Muñoz-Suñé, who heads the $1.1 billion U.S. arm of EIM, Arpad Busson’s Geneva-based fund of hedge funds. Muñoz-Suñé divides long-short equity managers into three subcategories based on market exposure: those that are up to 60 percent net long, those that are market neutral and a select few managers that vary their bias over time. In today’s especially treacherous markets, Muñoz-Suñé favors the less-common variable-bias breed, which may be as much as 80 percent long or short, depending on market conditions. “Very few people can manage from long to short on a net basis, even though everybody says they can,” he explains. “The majority of long-short equity managers have a net long bias of 20 percent to 60 percent.” Managers often focus on particular industries or make decisions based on geography. In theory, after all, it’s a stock picker’s game based on buying winners and shorting losers, but Muñoz-Suñé points out that in a massive sell-off like last year’s, the market does not discriminate. He says the directional bias of most long-short equity managers offers little protection in a one-way market, and although they can buy stocks at prices that may be a bargain looking out three to five years, it is pointless to do so if a fund can’t survive long enough to cash in. Recovery is tough when a fund is down 30 or 40 percent, as many “good value pickers” are, says Muñoz-Suñé. A fund that has fallen 40 percent, for instance, has to go up 67 percent just to reach its high-water mark and start collecting performance fees again. Paamco co-founder Knight says the best-performing managers today combine strong fundamental research skills with aggressive trading. How managers size their positions and when they make a move is critical too. “A number of people who are very good analysts fell down on portfolio management, and it really hurt them in 2008,” Knight notes. “They got whipsawed, and then they started violating other portfolio disciplines.” Some funds did much better than the indexes last year, and a handful even made money. A multitude of long-short equity managers have proven their worth since 2001, however. In five years during that period, the HFRI equity hedge index beat the S&P 500 index. The period includes not only three years when the S&P was down — when long-short managers ought to outper- form — but also five straight years in which the market was up. In two of those five years and over the five years compounded, long-short managers beat the market return even though they had less than 100 percent net market exposure, a clear signal that they delivered alpha to their investors. In many respects classic long-short equity managers — those who use little leverage and rely on fundamental research — hark back to the original hedge fund, created by Alfred Jones in 1949. Rady Asset Management, a $50 million firm based in La Jolla, California, follows a strategy that bears a striking resemblance to the Jones model. Harry Rady, the firm’s chief executive officer and portfolio manager, describes himself as “an old-fashioned value investor utilizing modern-day techniques.” What are those techniques? Rady, who says he has been using the same method for 15 years, screens stocks quantitatively and then divides them into three categories: names he would never invest in, ones that could be interesting at the right price and those that warrant further immediate research and include “buy now” picks. “We believe in buying the best at reasonable prices,” Rady says. “In this environment we get to buy the sexiest companies on the planet.” Last year’s market meltdown has given Rady an opportunity to purchase growth companies he had always deemed too expensive no matter how much he admired them (he declines to name names). On the short side, Rady looks for stocks that are merely overvalued rather than potential basket cases that could go to zero. The ideal candidate is a blue-chip stock where bulls have seized control and expectations for growth are already baked into the price. “If these companies meet or beat an earnings estimate the stock does nothing,” says Rady. “But if they miss market expectations they go down disp r o p o r t i o n a t e l y. ” H i s portfolio is typically as much as 80 to 90 percent long, 10 to 20 percent cash and 10 to 20 percent short. Recent volatility and the chance to buy cheap growth stocks have pushed Rady’s portfolio turnover up from its historical average of 30 percent per year, but it’s still comparatively low. Many mutual funds have much higher turnover. Rady’s long bias pulled him into the red in 2008 — he was down 12.85 percent — but he remains optimistic. “When managers are giving up stocks — because companies are going to miss a quarter or their funds have to meet redemptions — I can build positions in best-of-breed companies,” he says, “It’s exciting. It’s dangerous. But it has created more opportunity than I have ever seen in my career.” MARCH 2009 • INSTITUTIONAL INVESTOR’S ALPHA • 51
For optimal viewing of this digital publication, please enable JavaScript and then refresh the page. If you would like to try to load the digital publication without using Flash Player detection, please click here.