The major reason for that is an expected continuation of market volatility, like we have seen over the last month or two, as the US steps away from QE.
However, the other reason is that as markets normalise, not all stocks will move up and down together like they have done in the past.
There were already tentative signs, before the most recent market correction, that there was greater share price dispersions, with companies reporting good earnings being rewarded and those that disappointed being punished.
Though that sort of environment can be turbulent for investors, Mike Deverell – investment manager at Equilibrium – says long/short equity funds can make the most of it because they can bet on the winners and against the losers.
“We do quite like [long/short equity funds] as a diversifier as, in principle, when there is less stock price correlations there are clearly more opportunities for managers,” Deverell (pictured) said.
With that in mind, we look at two of the highest rated long/short equity funds in the IMA universe: CF Odey Absolute Return and Henderson UK Absolute Return.The £416m Henderson UK Absolute Return fund, which has a five crown-rating, was launched in its current form in April 2009 and is headed up by FE Alpha Manager Luke Newman and Ben Wallace.
It also features on the FE Select 100 and FE Research’s Charles Younes says it is a different type of portfolio to most others in the IMA Targeted Absolute Return sector as the managers don’t just use their short book as a hedge but as an active “profit centre”.
“Wallace and Newman aim to generate a positive return through profiting from inefficiencies in the UK equity market, regardless of what direction it is moving in,” Younes said.
“Their investment universe comprises large and medium-sized companies included in the FTSE 350 index. The portfolio is split between core and tactical sub-portfolios. Within the core portion, the managers hold shares of companies whose long-term earnings growth they feel is underappreciated by the market.”
“They can also short-sell shares of companies whose earnings growth they deem to be excessive and this technique allows to profit from a fall in companies’ share prices.”
Wallace and Newman go long and short in their respective tactical and core books, as they explained in an FE Trustnet article earlier this year.
“We are genuinely indifferent about the stocks we short as we will look at companies that have either been overbought or oversold. It’s typically the part of the fund that allows us to do well in volatile or falling markets,” Newman said.
The fund launched in its current UCITs format in 2009, but Wallace and Newman have been running the strategy for close to 10 years.
Though the data isn’t freely available, Newman says the tactical short book was the major reason why the strategy returned 28 per cent in the crash year of 2008 as they were bearish on banks and other highly-leveraged consumer facing companies such as retailers and housebuilders.
Deverell says the £823m CF Odey Absolute Return fund, which is co-managed by James Hanbury and Jamie Grimston, is a higher risk portfolio.
“The fund should be used within an alternative equity allocation because it isn’t your typical absolute return fund as you are getting a high level of equity market risk,” Deverell said.
“They are very much bottom up stock-pickers and the portfolio is a collection of their best ideas but then they have a macro overlay. For instance, they have shorts on gilts and treasuries, which hasn’t helped them this year.”
“While the Henderson fund is probably slightly higher risk than the average fund in the absolute return sector, the Odey fund is much more high risk. You’ve got to think of it as a type of equity fund if you looking to hold it over the longer term.”
The funds’ different styles are reflected in their return profiles. The Henderson fund was launched in April 2009 while the Odey fund was launched a month later. According to FE Analytics, CF Odey Absolute Return has gained 177.95 per cent while Henderson UK Absolute Return has returned 35.19 per cent.
As a point of comparison, the FTSE All Share is up 83.2 per cent.
Performance of funds vs index since Apr 2009
Source: FE Analytics
The Odey fund has also outperformed the Henderson one in each calendar year since the two funds were launched, though it is down 3.25 per cent year to date while Wallace and Newman have coped with the falls more effectively as their fund has returned 1.03 per cent so far in 2014.
Source: FE Analytics
However, as you can imagine, the Odey fund has given investors a much rougher ride. Its annualised volatility since launch has been 12.41 per cent, while the Henderson fund’s annualised volatility has been 4.09 per cent over that time.
CF Odey Absolute Return’s largest monthly fall over the last five years has been 11 per cent while Henderson UK Absolute’s biggest loss has been 4.5 per cent.
These are shown in the two fund’s maximum drawdown figures, which measure how much an investor would lose if they bought and sold at the worst possible time.
The Henderson fund’s max drawdown has been 5.03 per cent, which is three times less than the Odey fund’s.
The other major difference between the two portfolios is that the Henderson fund will only short individual companies, while Hanbury and Grimston short various indices including fixed income and currency markets.
The expert’s view
Clearly, Henderson UK Absolute Return suits a more cautious investor while CF Odey Absolute Return is a better fit for someone who is willing to stomach volatility in the pursuit of higher capital growth.
Deverell has used both funds within his client portfolios in the past, but he currently favours the Odey fund.
He likes the huge amount of flexibility that Grimston and Hanbury have and rates their stock-picking abilities.
However, to make sure his clients aren’t exposed to too much volatility, he pairs the fund along with the five crown-rated Old Mutual Global Equity Absolute Return fund.
The $1.9bn fund is also a long/short equity fund, though Deverell describes it as a more market neutral portfolio. It has returned 38 per cent over five years with a maximum drawdown of 6 per cent.
CF Odey Absolute Return has an ongoing charges figure of 0.93 per cent, while Henderson UK Absolute Return is more expensive at 1.07 per cent.
