Market Neutral Hedge Fund Factors Breezed Through Brexit Plungeby
Momentum trade sees its best two-day increase in five years
In flight to quality, short leg pays in long-short portfolios
Market neutral was the way to go after Brexit.
Strategies that employ offsetting bets to orient managers not around market moves but the performance of investment factors such as momentum and dividend yield were major winners as markets buckled following the U.K. referendum. Long-short momentum, in particular, posted some of its best relative returns in years.
The performance was a vindication for quantitative strategies that are something of a rage on Wall Street of late, investment programs that distance managers from big market swings while capturing performance discrepancies among individual stocks. The tactics were especially useful on Friday and Monday, as a marketwide slump paid off for neutral managers who found themselves short the right shares.
“It’s all on the short side. The reason momentum won so big was because the worst got crushed,” said Joseph Mezrich, managing director at Nomura Securities International Inc. “Same with dividend payers, same with profit. The ones that did well, it’s because the short side got crushed.”
The S&P 500 Index fell 5.3 percent in the two days after the Brexit vote. A market neutral strategy that bets on companies with the best returns on investment and against those with the worst gained 0.8 percent, while one focused on dividends rose the most since 2011, according to a Bloomberg U.S. equity model drawn from about 2,000 stocks. Long/short momentum gained 1.3 percent, its best two days since 2011, the model showed.
In each case the returns are explained by the performance of investment factors, Wall Street lingo for a list of stock characteristics that are used to reorder quantitative portfolios. Say a fund manager has no view on how the broader market will perform but expects that whatever happens, focusing on dividends will be the key to harvesting the best returns. She can adapt a market neutral strategy that goes long high-dividend companies and shorts lower ones.
Factors can be tied to virtually anything: how fast earnings are growing, the soundness of balance sheets, the relative volatility of shares, even how much trading volume occurs in a stock each day. In each case the fund manager tries to isolate the return of the factor, while reducing the impact of the overall market.
It was the short side that gave momentum the extra push that allowed it to take off as the rest of the market plunged after the U.K. vote. Bearish bets consisted of equities that were deemed as too risky by investors, dumped for higher quality names. Managers using the momentum factor ended up shorting the most volatile stocks, a prescription for success in Brexit’s aftermath.
“What happened during Brexit is basically the price volatility factor sold off, given that it is the most direct market indicator of quality: beta and volatility,” said Abhra Banerji, director of quantitative research at Evercore ISI. “Momentum outperformed as a consequence.”
Endo Pharmaceuticals Inc., with a 90-day historic volatility nearly 10 times greater than the S&P 500, is in both Evercore ISI’s long price volatility basket and short momentum basket. In this case, it paid to be short Endo. The health-care company slumped 14 percent the two days after the vote. The same can be said for Marathon Petroleum Corp., which fell 10 percent over that period and is also in the Evercore’s short portfolio.
The extent to which the short momentum bet succeeded is especially apparent when you break up each leg of the trade. A market neutral long momentum basket constructed by S&P Dow Jones Industries actually fell with the broader market, declining 4.2 percent Friday through Monday. That was OK because stocks in the short basket did much worse, losing 10 percent. A short bet against that leg meant that market neutral managers made out well.
“The way to think about that is that the stocks on the short side were high default risk companies,” Mezrich said “The long side plods along and there’s a lot of action in the short side.
A similar phenomenon played out with a long-short strategy that focuses on dividend payers. An S&P 500 index that tracks stocks that pay the most dividends had its biggest two-day fall since August. Yet the market neutral dividend strategy gained 0.7 percent, thanks to bets against stocks that don’t pay dividends.
As the S&P 500 bounced back Tuesday and Wednesday, the market neutral factors performed the reverse of the broader market yet again. Momentum fell 0.2 percent and growth was little changed on Tuesday.
“Post these sharp sell-offs, we find what fell the quickest recovers the quickest and vice versa,” said Banerji. “This is classic risk-off.”