Like hedge funds, absolute return funds aim to protect investors from the serious downside associated with difficult market environments. But limiting the downside doesn't mean investors can't enjoy decent upside, according to David Conlon of Merrion Investment Managers, whose High Alpha Fund has enjoyed excellent returns since its inception in late 2007.
The fund, which last month won the award for Best Global Macro Fund at the Acquisition International magazine 2016 Hedge Fund Awards, is up 241 per cent over that period. Annual gains have averaged 15.8 per cent (14.3 per cent if an annual management fee of 1.5 per cent is deducted), compared to 6.1 per cent for the MSCI World Index. The fund, which is led by Conlon, who has been chief executive at Merrion since 2013, has not lost money in a calendar year yet.
Absolute return funds don’t measure themselves against a particular benchmark. “We’re looking to do at least 7 per cent per annum irrespective of what the market is doing,” says Conlon.
Merrion, which takes a fifth of profits in excess of that 7 per cent hurdle, has “more than delivered” thus far, but “equally as important is the focus on preserving capital on the downside”. That, he says, “has been key in terms of how we manage the fund”.
Capital preservation
This focus on capital preservation means the fund actually gained 6.6 per cent during the global financial crisis in 2008, when international indices collapsed 40 per cent. High cash levels and very short holding periods were the norm back then, with Merrion gaining by taking short positions (positions that profit when markets fall) as well as going “opportunistically long” during 2008’s many bear market rallies.
The fund tends to outperform during times of market stress, such as during the first Greek bailout in the second quarter of 2010, the European sovereign debt crisis that dominated much of 2011, and the present global growth scare.
Last month, it gained 1 per cent and was never down by more than 1.3 per cent, despite markets suffering a brief but aggressive sell-off. Defensive positioning was key. At the end of January, cash and treasury bills accounted for almost three-quarters of its portfolio.
Excessively pessimistic market sentiment coupled with improving fundamentals resulted in increased equity exposure as the month progressed, with the fund benefiting from the market rebound.
Twists and turns
Obviously, no fund catches every market twist and turn. Much of the High Alpha Fund’s marked outperformance can be traced back to 2008 and 2009, when it gained 62 per cent. In 2010, 2012 and 2013 – all big years for global equities – it failed to keep up with the MSCI World Index, even if the aim of posting annual returns of at least 7 per cent was achieved on each occasion.
Outperformance was resumed in 2014 and 2015, with last year’s 16.7 per cent return an especially strong gain in a flat year for global indices.
"We certainly don't claim to get it right every time, whether in this fund or any other fund that we manage," says Conlon. "I think Bernie Madoff might have been the last person to claim that!"
However, the High Alpha Fund gets things right more often than wrong, he says, with the fund recording positive quarterly returns roughly two-thirds of the time.
Moreover, its largest quarterly gain (33.4 per cent) is four times larger than its largest quarterly loss (-8.4 per cent), while the average quarterly positive return (7.9 per cent) dwarfs the average quarterly negative return (-3.1 per cent).
Other risk-reducing mechanisms include the use of stop-loss orders, where a trade is exited if a position trades below a predetermined level, as well as the purchase of put options to provide a form of portfolio insurance. Positions are “typically” held for “at least a month to three months”, with some held over the course of a full year, although holding periods would potentially be “a lot shorter” in more volatile conditions.
Hedge fund woes
The success of the High Alpha Fund is in stark contrast to the overall hedge fund industry, which has consistently disappointed in recent years. A number of high-profile firms such as BlueCrest and
Seneca Capital
have recently closed their doors to external investors, while hedge fund giants such as
Bill Ackman
of
Pershing Square
and
David Einhorn
of
Greenlight Capital
have suffered heavy losses over the last year.
Different funds underperform for different reasons, although Conlon cautions that size “has to be an issue” for the bigger hedge funds. Funds “need to be very active, nimble and tactical”, he says, “and that’s very difficult to achieve when you are trying to move around $15 billion (€13 billion) to $20 billion of investors’ money”.
With less than €100 million in assets under management, the High Alpha Fund remains a relative minnow, although Merrion has ambitious plans to grow the fund.
Assets under management have doubled in the last 18 months, says Conlon, and preliminary estimates suggest the firm’s current strategies could be implemented successfully even if assets under management were to mushroom to €10 billion.
Three pillars
Size aside, Conlon cites Merrion’s “style-agnostic” approach as an advantage. Eschewing specific investing styles such as value or growth investing, he says Merrion’s approach is based on three pillars: valuation, macroeconomic conditions and technical analysis.
Technical analysis – essentially, the study of market action and prices – is regarded by many academics and some fundamentally-minded investors as voodoo, but Merrion has been using it successfully for two decades, says Conlon. More an art than a science, those looking for a magic technical formula will be disappointed, but “we certainly find it useful in terms of identifying entry and exit points”.
Technical analysis can also help avoid value traps, “where a market looks cheap but it keeps on falling or a sector looks attractive but it keeps underperforming the market”.
By the same token, a sector may appear technically healthy but expensive. Similarly, some stocks or sectors may look cheap but the economic situation is murky. Alternatively, the macro picture might be bright but if a region is trading at a premium relative to history, it would indicate the good news is already priced in. No one pillar determines the investment process. “It’s the three of them, the interaction of the three, that is key,” he says.
Outlook
As for the near-term outlook, things are “far from certain”. Globally, equities are “slightly cheap”, trading at a 5 to 10 per cent discount relative to history. That’s good news for investors with a 10-year investment horizon, who should enjoy slightly above-average returns, but the current discount is “not a huge short-term cushion if the macro concerns that are out there were to unfold”, Conlon says.
US stocks are more expensive than other regions and, although the S&P 500 has suffered less technical damage than most indices, there is nevertheless a “big question mark” as to whether the seven-year bull market is still intact, given 2016’s volatility and the fact it’s been 10 months since the index hit new highs. There are, says Conlon, a lot of “mixed messages” abounding at present, so position sizes will be reduced to reflect their “reduced conviction”.
Irrespective of what transpires, Conlon believes the High Alpha Fund will continue to deliver annual returns of at least 7 per cent. Absolute return funds have come to be associated with low-volatility funds that deliver steady annual returns, but too much focus on low volatility may be counterproductive, he cautions.
“It’s quite difficult to build a decent pension pot with annual returns of 3 to 4 per cent. As nice and consistent as they are over time, you want to be putting in a huge amount of contributions to end up with a satisfactory pension, something that I don’t think is fully appreciated in the marketplace yet.
“An extra few per cent per annum makes a hell of a difference.”
