Winning at the loser's game: a strategy for absolute return investing
Posted by Guest in Portfolio management category on 03 Mar 17
Some of the terms used in this article are explained in a glossary at the end.
Tennis may not immediately come to mind when someone mentions absolute return investing. But for us, tennis – particularly in its amateur form – can provide a good metaphor for the challenge that absolute return fund managers face when managing their clients money.
A well-known finance academic called Charles D. Ellis famously made this analogy in a paper called The Loser’s Game. Ellis argued that given how highly professional investing had become, it was difficult for all investors – professional and amateur alike – to perform better than the market average over the long term.
Faced with fewer and fewer clear market inefficiencies to exploit, fund managers could no longer succeed by trying to pick big winners. Rather, success came from playing the ‘loser’s game’, a description he applied to successful tennis amateurs who triumphed by making fewer mistakes than their opponents. The goal was to get the ball back in court and capitalise on the mistakes of others.
For us, this way of thinking implies a focus on risk management. When we are managing the Jupiter Absolute Return Fund, we consider ourselves risk managers first and foremost. And we believe it is important to tell clients about the sorts of risks we take on their behalf and to understand what our ‘edge’ is when it comes to our investment strategy.
A long/short approach to investing
Absolute return investing is a broad church and no two managers approach the discipline the same way. In essence, absolute return investing aims to achieve a positive return over a certain period of time irrespective of the wider stock markets going up or down. Our approach is called “long/short equity” investing. This means we look to buy (or go ‘long’) stocks we believe are attractively valued and sell (i.e. ‘short’) stocks we believe appear overpriced and have a potential catalyst – like a profit warning – that suggests a heightened probability the stock might fall in value.
Why have we chosen to invest using this approach? There are two key reasons. First, my academic research was on short-selling and this has given us a potential ‘edge’ when it comes to understanding the intricacies of this investment area. Second, when combined with long positions, I believe short-selling can help a fund produce fairly consistent returns at potentially lower levels of risk, although this is not guaranteed.
What is short-selling?
Short-selling is relatively uncommon in the wider fund management industry but is quite a common strategy for absolute return funds. To sell ‘short’ is to effectively sell an asset you don’t own with the aim of buying it back more cheaply when the price of that asset falls. If you sell the stock of XYZ plc for £1.00 and it falls in value to £0.90, you could potentially pocket £0.10 per share. In practice, there would be fees associated with this transaction and we would enter this sort of trade using derivative contracts – a concept I will explain a little later.
Short selling comes with risk. When you buy a stock, you can’t lose more than the initial cost. In the case of shorting, your losses are potentially unlimited – care is obviously required. However, there is evidence that short-sellers tend to be better informed (on average) than other investors. This is in part because the risks and costs of this activity can lead to a higher level of scrutiny about a stock than the average investor (although this is not always the case). So understanding the signals given off by the activities of these investors can have potential benefits. That is our area of specialisation.
In fact, the combination of long and short stock positions can have an interesting impact on the fund’s risk profile. In theory, holding the same amount of long and short positions can help to limit the impact of overall market volatility (i.e. price fluctuations) on returns. For example, say we held a £10,000 basket of stocks we believed were attractively priced, versus a £10,000 basket of short positions we believed were overvalued. In this case, profits (or losses) would be caused by the relative movements in the prices of the underlying stocks rather than the direction of the market. This type of ‘market neutral’ strategy speaks to the aim of an absolute return fund, which seeks to add value independent of whether the market is rising or falling.
Traditional ‘long only’ stock market funds have far fewer tools at their disposal when managing the impact of market volatility on fund returns. They tend to hold a diversified basket of stocks to help alleviate stock-specific problems. Not putting all your eggs in one basket means that a disappointment by one holding won’t rock the boat too much. But these traditional funds can do little to limit the effects of a widespread fall in the value of the market, apart from perhaps moving out of stocks and into cash. In reality there tends to be limitations in fund investment policies when it comes to that course of action.
In the Jupiter Absolute Return Fund, our long and short exposures have been roughly in balance for over a year, which has mostly been a consequence of the sorts of stock-specific opportunities we have found. During the more turbulent times last year – in January when markets fell sharply and after the Brexit vote – this positioning proved beneficial and the fund actually made money at those times. Of course, there is not guarantee this positioning will perform as well in future.
Preparing for bad scenarios
When trying to win at the loser’s game, we strive to make the portfolio as robust to change as we feasibly can. Change is one of the few certainties when it comes to financial markets and despite my experience and academic background, I find forecasting economic, political or social phenomenon very difficult. Many of my colleagues feel likewise. Building robustness is therefore not about trying to second guess where the market might be going, but looking out for signs of how markets are evolving and assessing what impact changes might have on the fund. We may not be able to forecast the future or anticipate all potential outcomes, but we can work hard to prepare the portfolio for many scenarios. As part of this process, we constantly assess the combination of long and short positions in terms of their robustness to different scenarios (such as Brexit last year).
Another approach we use to help achieve this involves seeking to ‘hedge’ against bad scenarios. Establishing a hedge is like buying insurance on your home to mitigate specific risks, like fire or flooding. Within the fund, we use a number of techniques to help provide ballast and to potentially profit from unexpected market conditions. We might hold securities like government bonds (i.e. debt securities issued by governments) or invest in gold, both of which tend to perform robustly at times of market distress. We might also use derivatives, which can be good instruments for building robustness into the portfolio. However, this form of insurance comes at a cost which can eat into the upside return of the fund.
Overcoming behavioural biases
Winning at the loser’s game means making fewer mistakes than your opponent, so another important aspect of our investment approach is to try to limit the behavioural problems – such as over or under-reacting to new market information – that can afflict all investors and seek to capitalise upon those in others. To this end, we take modest position sizes and act incrementally, rather than dramatically, to new information and stories about stocks. We find that this can help us avoid under and over-reacting to change and means that we continually re-check our original thinking about a position, carefully weighing up the value of new and old information.
In trying to win at the loser’s game, we therefore combine long/short stock market investing with hedges against bad scenarios and strategies to limit behavioural biases. This has been a largely successful approach since I took over management of the fund in September 2013, although we know intimately that past performance is not guarantee of future returns. As such we are careful not to rest on our laurels, but rather continually seek to improve our investment approach and maintain our investment edge. To this end we read widely on the theory and evidence of short-selling. We work with academic researchers to try to improve our processes. And we train, practising our craft, which is something we have done over many years. Ultimately we believe the mix of theory, evidence and practice should put us in the best position to adapt to an uncertain future as we strive to generate an absolute return for our investors.
Past performance is no guide to the future.
The fund’s benchmark is the 3 Month LIBOR in GBP, which is a cash interest rate.
: FE, bid to bid, basic rate tax, net income reinvested. Jupiter Absolute Return I Acc in GBP, as at 31.01.2017.
Please note market and exchange rate movements can cause the value of an investment to fall as well as rise, and you may get back less than originally invested. The fund manager can use derivatives for investment purposes, to take long and short positions based on their view of the market direction, so the fund's performance is unlikely to track the performance of broader bond and equity markets. Taking short positions creates the opportunity for a fund to deliver positive returns in falling markets, but also means that a fund could deliver negative returns in rising markets. The potential loss on a short position is unlimited, because the price of the underlying investment can carry on rising. There is also a risk that counter-parties to derivatives may become insolvent, which may cause losses to the fund. This fund invests in securities issued or guaranteed by the United Kingdom which may exceed 35% of its value.
The Key Investor Information Document, Supplementary Information Document and Scheme Particulars are available from Jupiter on request.
In fund management speak, ‘absolute return’ simply means the actual increase or decrease in an investment, as opposed to how an investment fund might perform relative to a benchmark like a stock market index or cash rates. As such, absolute return funds typically seek to generate positive returns (over a certain period) regardless of whether the market is trending up or down. This is no mean feat. That’s where the loser’s game metaphor comes into play.
A financial instrument that derives its value from its underlying assets. Common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indices. Futures contracts, forward contracts, options and swaps are the most common types of derivatives. Derivatives can be purchased ‘on margin’, i.e. at a fraction of the value of the underlying asset. Thus, they are ‘leveraged’ instruments where the risk of loss can be greater than the initial outlay. Derivatives can be used like insurance contracts (i.e. to hedge market risk) or for investment purposes.
An investment designed to reduce the risk of adverse price movements in an asset by taking an offsetting position. Derivatives are usually used as hedging tools.
Buying a security with the expectation that it will deliver a positive return if its value goes up or a negative return if its value falls.
Short selling involves the sale of an asset that has been borrowed from a third party with the intention of buying the asset at a lower price at a later date. It is a way of making a profit when the price of a security falls.
This article is for informational purposes only and is not investment advice. We recommend you discuss any investment decisions with a financial adviser, particularly if you are unsure whether an investment is suitable. Jupiter is unable to provide investment advice. Past performance is no guide to the future.
The views expressed are those of the fund manager at the time of writing (March 2017), are not necessarily those of Jupiter as a whole and may be subject to change. This is particularly true during periods of rapidly changing market circumstances.
Every effort is made to ensure the accuracy of any information provided but no assurances or warranties are given.
Jupiter Unit Trust Managers Limited (JUTM) and Jupiter Asset Management Limited (JAM), registered address: The Zig Zag Building, 70 Victoria Street, London, SW1E 6SQ are authorised and regulated by the Financial Conduct Authority.
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The views and opinions contained herein are third party and may not necessarily represent views expressed or reflected by Willis Owen.
: we do not give investment advice so you will need to decide if an investment is suitable for you. If you are unsure whether to invest, you should contact a financial adviser.