Hedge funds, dogged by years of so-so returns during soaring stock markets, appeared poised to shine starting last summer. That’s when global equity markets turned sour on news of a slowdown in China and the prospect that the Federal Reserve would finally raise its benchmark interest rate.
But many funds continued to disappoint, particularly equity managers with high net exposure to the stock market, as the S&P 500 ended 2015 down 0.73 percent. One hedge fund strategy stood out during the period, however: equity market-neutral funds, those long-short strategies that hedge out exposure to the broad stock market.
These funds excelled while many of their peers got crushed in last year’s turbulence. In 2015 the HFRI Equity Market Neutral Index posted a 4.36 percent gain, compared with a 1.12 percent dip in the HFRI Fund Weighted Composite Index.
A rise in cross-sectional volatility — the amount of movement across all stocks in a given universe at a certain point in time — has been one of the driving forces behind the outsize performance, according to Jacques Friedman, a principal and head of global stock selection at Greenwich, Connecticut–based AQR Capital Management.
As a result, the rocky start to 2016 bodes well for market-neutral managers. “Environments of higher cross-sectional volatility are usually good for the strategy,” Friedman says.
AQR has employed equity market-neutral strategies in its multistrategy funds since the firm launched in 1998. “Equity market neutral serves as a good core component of a hedge fund portfolio because, by construction, its returns are uncorrelated to the swings in the market,” says Friedman.
AQR started the Global Stock Selection Fund, its first stand-alone fund devoted to the strategy, in 2000. Now it manages $1.5 billion in assets between the commingled limited partnership and a mutual fund that’s based on the same quantitative models and launched in the fall of 2014.
The latter returned 17.6 percent in 2015. However, last year was remarkably good, and Friedman notes that the fund targets an annual return closer to 5 percent.
Equity market-neutral strategies come in a variety of flavors. Some focus on specific geographies or industry sectors while others may rely on quantitative models or fundamental analysis. What they all have in common is a goal of generating positive returns regardless of conditions in the markets.
That attribute can become less attractive during bull markets. “In a strong, rising market, market-neutral managers are going to lag other long-short managers, so the amount allocated to market neutral as a percent of overall assets shrank significantly from 2009 to last year,” says Don Steinbrugge, managing partner of Agecroft Partners, a third-party marketing firm for hedge funds. “But I think now that’s going to reverse.”
Although market-neutral funds offer diversification benefits within multistrategy portfolios, they also tend to be highly diversified on their own. “We have high conviction in the investment process and in our model and very low conviction in any one stock,” Friedman explains. “It’s a very different animal than some other hedge fund asset classes where you could have very concentrated positions.”
