Sarah Godfrey talks to BlackRock UK Absolute Alpha lead manager Mark Lyttleton about longs, shorts and why investors should get over their fear of derivatives
Behavioural finance studies have shown that the majority of investors measure the success of their holdings against the risk-free return on cash. This is in curious contrast to the majority of funds, which measure their returns against each other or an index. In difficult markets such as we are experiencing so far in 2008, a top-performing fund may well be one that has fallen less far than its peers, but that will be little comfort to the investor, who will be wistfully eyeing the 5% or so he could have got from a decent deposit account over the last year.
In an attempt to address this anomaly, the past few years have seen the launch of several funds designed to produce an absolute return - that is, not to lose investors money. They go about this in a multitude of ways, some holding equities and others bonds, while some adopt a multi-asset approach. Some have specified performance targets while others do not. All of this makes them rather hard to compare with each other.
But while some have come under fire for failing to meet their self-imposed targets - and in some cases for failing even to make money - BlackRock UK Absolute Alpha has been gathering an increasing number of supporters.
The fund is a long/short equity fund that takes advantage of the Ucits III rules to produce a portfolio reminiscent of a market-neutral hedge fund but within an FSA-recognised UK Oeic structure.
"The investment process is very complicated," jokes lead manager Mark Lyttleton. "I try to buy shares that will go up and short shares that will go down." In a perfect world, he says, he will make money from both. "I also try to put in pairs trades where I think one share will do better than another - it takes out a lot of the market and sector risk and means I am just left with the stock risk. I end up with a portfolio with very low net exposure to the market, but where there are still quite a lot of stock views being taken."
The process is more bottom-up than top-down, though Lyttleton points out it is very difficult to look at shares in a vacuum: the wider economy will always have an effect.
Under the Ucits III rules, Lyttleton is not allowed to use so-called 'naked shorts' - those involving actual shares. Instead, the short positions are 'synthetic shorts' using contracts for differences (CFDs).
While the pairs trades (one long and one short holding, generally in the same sector) reduce the net market exposure, they do not cancel each other out entirely, Lyttleton explains.
"If I am long BP and short Shell (which I'm not, incidentally), as long as I think their prospects are exactly in line with one another, they will move in line," he says. "In real life, their prospects are not the same. I am not taking a view on the market - the size of the stocks means they would cancel that out - or on the oil price, as they are both exposed to that, but just BP as a company and Shell as a company. I am not clever enough to predict the market or the oil price, so I have taken away what I don't know and boiled it down to what I do know: that BP has better prospects than Shell.
"The pairs trades have proved a very consistent positive contributor to our return," he adds.
Lyttleton works closely with BlackRock's risk group to minimise dangers to the portfolio, making sure the risks are identified, controlled, spread evenly and not running too many cross-correlations between the longs and the shorts. "We need to ensure no individual holdings, strategies or styles will make or break the performance of the fund," he says. "We don't want something to go wrong that would cause us to lose 2% or 3%. It is very different from something like a hedge fund - a lot of those were down anything from 3% to 10% in January. We don't want -5% months; it's not the style of fund we are running. We don't get +5% months either, for the same reason."
The recent market volatility and bearishness has pushed up the price of CFDs marginally, as fewer people are willing to bet on certain stocks going up, but Lyttleton says his unconstrained style has meant this has had little effect on his portfolio, as he can simply avoid the "crowded shorts".
In fact, he says it is quite a fertile time for the fund, with good opportunities to be found on both the long and short sides. "In the short term, certain risks are slightly mispriced, and that's a great opportunity for us on a six to 12-month view," he explains.
While Lyttleton has the ability to take the fund up to 100% in cash, he says that over the fund's three years of life so far, the weighting has tended to be in the 5-15% range. At 15% it is currently at the top of that range, driven by uncertainty in the market. "I will only put positions in where I have very high conviction - if necessary I will wait a bit," he says.
The manager sees the volatility in the market persisting for at least the next six to 12 months, punctuated by periods of relative calm. "Markets will be driven more by macro than by micro factors," he says. "The outlook for global GDP, inflation, interest rates and credit will be the key features driving the market. It's a fairly uncertain picture - there is a slowdown in the US and the start of one in the UK, but no-one knows how deep it will be. Asia is still strong but no-one knows if that will continue.
"We are watching closely and carefully. The portfolio is quite well positioned for what is going on, and if things changed, we would adjust it accordingly. Our net position is very low; we have increased the amount in pairs trades, so we do not have a strong view on the market or sector level but we have quite a large number of individual stock bets - which, after all, is what we are paid to do."
He adds that he is a little cautious on the outlook for equities, as what is going on in the credit market is not yet reflected in stocks. "If the market sold off by 10%, I would be more optimistic," he says.
While there is no denying Lyttleton's success with the fund in performance terms, investor appetite for it was slow to begin with and has only recently picked up momentum, with funds under management now approaching £500m.
"The past six months have shown what the fund is capable of, and we have produced a 35% return in three years, so it feels pretty robust," he says. "When we launched the fund it was a huge reputational risk for BlackRock because it was a very new way of doing things. As time has gone by, people have got more comfortable with the process - they have seen it is low volatility and low correlation. But it takes time for people to get comfortable with it."
Investors may be more used to the traditional relative-return type of fund, and perhaps still wary of what they see as esoteric financial engineering. But the loss-aversion identified by the proponents of behavioural finance may yet win the day and see funds like Lyttleton's become truly mainstream.
"It is a very sensible part of a portfolio, though whether it is a core or a satellite holding is a question for the individual," he says. "There will be times when equities do better and times when they do worse, and we have seen both in the past couple of years. In the fullness of time, a lot of clients will have funds like this - maybe even all of them."
Mark Lyttleton joined BlackRock (formerly Merrill Lynch Investment Management, and before that Mercury Asset Management) as a graduate in 1992. He has been investing in UK equities for 15 years and has managed the BlackRock UK Absolute Alpha fund since its launch in April 2005.
Lyttleton also manages the ML UK Dynamic fund and the ML UK fund, and has overall responsibility for more than £2bn of assets under management. He has an AA rating from Citywire.
ASK THE EXPERT
Marcus Brookes, head of Cazenove Multi-Manager
We already own this fund in two of our multi-manager portfolios. It is the single largest holding in our highest-profile fund, Multi-Manager Diversity, at 8% of the portfolio.
The key thing I really like about the fund is that it will be no more than 20% long or 10% short, so it is pretty much market-neutral. It has an incredibly low beta because it has very little net exposure to the market, and it doesn't gear so we don't need to worry on that front.
A minimum of 50% of the fund is in pairs trades, usually within the same sector, so if there is a sector issue, the net position will be unaffected. Having the core of the portfolio in pairs helps us gain confidence that the overall volatility will be quite low.
This fund is the poster child for absolute returns in the FSA-regulated market. It has delivered strong, consistent, low-volatility performance and that's why it can be such a big position in our funds. In the 11 quarters since its launch, the fund has made a positive return in every one, and even just in January, when markets fell by 10-12%, it didn't have a single negative day. We are very happy holders of this fund.
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