McDermott told FE Trustnet earlier this year that he held Newman and Wallace’s £447m fund in his pension and says that if investors are looking for equity-like returns with less volatility, it is a very good choice.
“It’s one of my favourite funds,” McDermott (pictured) said.
“There are a number of different funds in the absolute return sector. Some of them are very defensive and try to generate a small positive return and there are others which try and deliver a higher level of returns. I would put Luke and Ben in the latter category and they are the best I have come across.”McDermott is a fan of the fund due to the managers’ strategy, which is relatively unique to most funds in the IMA universe.
The large majority of funds that have the ability to short, or sell a borrowed asset in the expectation it will fall in value, will only use this power to hedge against risk or to help generate a positive total return.
However, FE Alpha Manager Luke Newman says a lot of his peers do not use their opportunities to short efficiently or effectively enough.
Newman says his and Wallace’s short book on Henderson UK Absolute Return is far more than just a defensive strategy and has long been their “profit-centre”.
“The heart of what we do is that we have never thought it is right to have a portfolio of predominantly long positions and then just a few lazy index futures,” Newman said.
“When you do that, I don’t think you are using the full scope of these opportunities available to you and you are not giving your investors what they should be getting.”
Newman and Wallace have run the strategy in an offshore hedge fund for more than 10 years, but they launched their current offering, which sits in the IMA Targeted Absolute Return sector, in April 2009. According to FE Analytics, the fund has returned 38.81 per cent.
While the FTSE All Share has delivered a much higher return over that time, Henderson UK Absolute Return has been three times less volatile.
Performance of fund vs sector and index since Apr 2009
Source: FE Analytics
The fund has had a maximum drawdown of 5 per cent over that time, which is three times less than that of the UK equity market.
The managers have delivered a positive return in each calendar year since launch, except for the falling market of 2011 when the fund lost 0.44 per cent.
Instead of just shorting the index to hedge risk and then generate alpha by taking long positions, like a number of funds in the sector, the two managers will only short individual stocks.
The major reason why Newman only shorts stocks is because managers who use index futures can come into trouble when there is a style shift in the market; like we have seen in 2014.
He says a lot of managers were taking long positions in mid-caps to generate excess return and then trying to cover themselves by shorting the index.
However, as mid-caps sold off earlier this year it has been mega-caps, which account for the highest proportion of the index, that have led the market.
“The problem is, when you just use FTSE index futures and there is a change in style, you are hurt by both your long and short positions,” he said.
The fund is up 2.13 per cent so far this year, outperforming the sector average in the process.
Performance of fund vs sector and index in 2014
Source: FE Analytics
The managers split their portfolio into two books; their core and tactical books. Their core book is filled with more long-term themes.
Newman says classic examples on the short side are companies that have been slowly pushed aside by the internet, such as classic retailers, telephone directories and music and game retailers.
The tactical book, however, is much more flexible and pragmatic, according to Newman.
“Our tactical book is the larger of the two and typically makes up around two thirds of NAV,” he said.
“We are genuinely indifferent about the stocks we short as we will look at companies that have either been overbought or oversold. It’s typically the part of the fund that allows us to do well in volatile or falling markets.”
The managers had held mining and natural resources companies in their tactical long book at the start of the year as they felt the sector had been oversold due to deep scepticism that managements were turning more shareholder friendly.
However, as sentiment turned more positive, Newman and Wallace have initiated a number of shorts because the sector has rallied strongly over recent months.
Though the data isn’t freely available, Newman says the tactical short book was the major reason why the strategy returned 28 per cent in the crash year of 2008 as they were bearish on banks and other highly-leveraged consumer facing companies such as retailers and housebuilders.
Newman points out, however, that his and Wallace’s decision to short stocks isn’t down to a macro call.
Performance of index over 2yrs
Source: FE Analytics
Following the strong performance of UK equities over recent years, a number of experts have voiced concerns over the immediate outlook for risk assets due to high valuations, a lack of underlying earnings growth and growing macroeconomic headwinds.
“Everything we do is driven by what we see at a stock level,” he said.
“Is it easier for us to find more shorts now? Yes, but we can still find opportunities in our long book.”
The managers’ biggest “long” theme is financials, particularly the insurance sector.
One of Newman’s favourite stocks is L&G as it should perform well in a benign or aggressive interest rate cycle.
It also among a number of companies they like that is increasing its dividend ahead of earnings; which the manager says is a sign of confidence on the part of the management.
Though the fund has performed well, given that the managers are very active with long and short positions, its ongoing going charges figure (OCF) is relatively high 1 per cent.
However, FE Research’s Charles Younes says investors shouldn’t be overly concerned about paying the slightly higher charges for the fund.
“Despite being expensive, this portfolio offers investors access to a successful hedge fund strategy. Wallace and Newman have extensive experience of UK equity markets and the entire investment process is centred on their ability to spot inefficiencies,” he said.
“Having been confronted with very different market conditions over the last 10 years, the investment process has proved to be successful and has met the managers’ risk and return objectives.”
He added: “Because the fund’s performance is not linked to the overall direction of the UK equity market, it can be used to complement an already balanced portfolio as it will likely add further diversification.”
The fund sits on the FE Select 100.
