LMCG Global Market Neutral Strategy A Brief History

Transcription

1 LMCG Global Market Neutral Strategy A Brief History Jeffrey P. Davis, CFA Chief Investment Officer INTRODUCTION: WHY GLOBAL MARKET NEUTRAL? Jeffrey P. Davis, CFA Chief Investment Officer Market Neutral strategies are several decades old, and many were either burdened with high fees, used leverage inappropriately, or weren t really market neutral at all. However, there is lasting appeal in generating profits for investors that are highly independent of the direction of stocks, interest rates and credit spreads, while charging a reasonable fee. Godon A. Johnson, PhD, CFA Lead Portfolio Manager International and GMN Team In the search for a team that could deliver this type of return, Lee Munder Capital Group, LLC (LMCG) recruited Dr. Gordon Johnson and his team of seasoned professionals in The quantitative team had already worked together for over six years and had developed a unique approach to equity research. They demonstrated that they could not only identify stocks that would outperform global markets over time, but also those that would underperform. This led to the development of a market neutral approach that could avoid the market-timing aspects required of other alternative strategies to be successful. Market neutral takes advantage of their skill in two separate ways long and short trading. The team had also created their own approach to risk management supported by two external risk management systems. Shannon M. Ericson, CFA Portfolio Manager & Analyst International and GMN Team The LMCG Global Market Neutral strategy (GMN) was ultimately launched in The team was backed by a solid foundation of experienced Operations and Compliance professionals to support this bottom-up quantitative strategy. Since our firm s inception in 2000, we have been managing a wide variety of long and short trading, and have been able to establish consistent trading and settlement functionality in over 35 markets around the world. Initially available only for internal assets, we believe the LMCG GMN strategy has demonstrated its validity as a liquid alternative absolute return investment. This white paper summarizes our experiences in this strategy since its inception in 2007 through the end of 203. Vikram K. Srimurthy, PhD, CFA Portfolio Manager & Analyst International and GMN Team

2 THE KEY CHOICES IN CONSTRUCTING GLOBAL MARKET NEUTRAL In advance of the strategy s launch in April 2007, the team made several key decisions that continue to position the strategy as a conservative alternative investment vehicle. NO LEVERAGE WITH THE CASH RECEIVED FROM SHORTING: Many strategies will take the cash received when short selling a basket of securities and use it to buy index futures on interest rates or equities, in order to boost returns. While this introduction of long beta can improve returns, it has the potentially negative effect of raising correlation with stocks and bonds increasing the chance that a portfolio will decline when stability is needed most. Alternatively, the cash can return the current U.S. Federal Funds Rate (minus a small fee charged by the prime broker) resulting in almost no duration risk and delivering a higher yield should interest rates rise. During the history of the strategy, yields on cash fell dramatically, so little of the return we discuss is related to yield on cash and collateral (meaning returns resulted primarily from long and short stock selection). Exhibit : With the decline of the Fed Funds rate, the strategy s returns have been mainly driven by long and short investments. U.S. Federal Funds Target Rate Present 6.0% 6.0% 5.0% 5.0% 4.0% % 4.0% 3.0% 3.0% 2.0% 2.0%.0%.0% 0.0% % % Source: FactSet. USE AS MANY EQUITY MARKETS AS FEASIBLE: The appeal of global investing is the opportunity to provide greater diversification and increase return opportunities. Compared to approaches that are wedded to a single market, the difference in the strength of stock selection among markets can be critical in generating consistent returns. This is true of the experience of the LMCG GMN strategy within the U.S. and outside the U.S. as seen in Exhibit 2. 2

3 Exhibit 2: Since U.S. and International markets don t move in lockstep, global exposure is critical to generating consistent returns and diverse sources of alpha. Calendar Year Sources of Return U.S. vs. International Returns (%) * U.S. International Source: LMCG data using FactSet.* Inception of the strategy was 04/0/2007. Return contributions shown are calculated using representative account holdings. Gross Performance is net of transaction costs as well as certain borrow costs and tax withholding on foreign dividends. Returns are calculated for the long and short portfolios and added together to get an overall contribution to return. They are aggregated for stocks traded in the U.S. versus those in developed markets and weighted in a representative LMCG Market Neutral account. Past performance is not indicative of future results. Shown as supplemental information only and complements the Global Market NeutralComposite returns and presentation in the Appendix. PROTECTING ON THE DOWNSIDE IS PARAMOUNT: The long and short returns of the strategy provide an additional layer of diversification and return opportunity. Most active portfolio managers attempt to identify long equity investments they believe will outperform an index. With shorting strategies, managers attempt to identify stocks that are typically discarded work the ability to capitalize on a security s price decline. This method improves upon approaches that short with ETF Index products or futures in that short alpha from stock selection may also be generated. Returns from longs and shorts will differ dramatically depending upon the overall trend of global equity markets. For example, Exhibit 3 shows that short positions were significant positive contributors in 2008, while long positions were the leaders in 203. When the net of the long and short positions is positive and greater than the fees, the strategy provides a positive absolute return. The cash and collateral may also provide additional yield. 3

4 Exhibit 3: Risk exposures can be offset by longs and shorts, particularly exposure to market direction. Calendar Year Sources of Return Longs vs. Shorts Returns (%) * Longs Shorts Source: LMCG data using FactSet.* Inception of the strategy was 04//2007. Return contributions shown to the left are calculated using representative account holdings. Gross Performance is net of transaction costs as well as certain borrow costs and tax withholding on foreign dividends. Returns are calculated for the long and short portfolios and added together to get an overall contribution to return. They are aggregated for stocks traded long and short and weighted in a representative LMCG Market Neutral account. Past performance is not indicative of future results. Shown as supplemental information only and complements the Global Market Neutral Composite returns and presentation in the Appendix. Ultimately, our team constructed a portfolio that can be represented by this diagram: Exhibit 4: The Market Neutral return profile is based on four basic elements, with Long and Short Returns being the primary drivers. Federal Funds Return Long Return Short Return Fees LMCG GMN Return 4

5 LESSONS FROM RETURNS AND DRAWDOWNS The management of the strategy overlapped with one of the most turbulent periods in modern financial history providing a serious test of management controls. Not only did this period include the disastrous fourth quarter of 2008, but it also included short periods of extreme stress, such as the Euro crisis and the shocks in the bond markets in 2007 that preceded the financial crisis. Note the relative stability and stable growth of the cumulative returns of the LMCG GMN strategy compared to the S&P 500 Index. Exhibit 5: The LMCG GMN strategy s diversification, risk management and alpha generation have provided stable growth relative to the choppier returns of the S&P 500. Cumulative Composite Returns 04/0/2007-2/3/ Returns (%) /07 2/07 08/08 04/09 2/09 08/0 04/ 2/ 08/2 04/3 2/3 LMCG GMN strategy (Net) S&P 500 Source: LMCG data using FactSet. Inception of the strategy was 04/0/ /30/07 return is from 04/0/2007-4/30/2007. Net returns are calculated by applying the management fee to the monthly gross returns of the accounts included in the composite. Past performance is not indicative of future results. Shown as supplemental information only and complements the Global Market Neutral Composite presentation in the Appendix. One of the key drivers of generating stable returns was the strategy s ability to avoid significant drawdowns during market stress periods of the past seven years. Exhibit 6 highlights how the LMCG GMN strategy fared better than hedge funds in protecting investor capital against equity declines. In particular, it provided downside protection when it was needed most during the financial crisis of Exhibit 6: The LMCG GMN strategy provided stable returns by avoiding big drawdowns during periods of market stress, as compared to equity markets and even hedge funds. Stress Periods July 2007 (First CDO Crisis) Jan-Dec 2008 (Financial Crisis) May 202 (Euro Crisis) LMCG GMN Composite (Net)* S&P MSCI AC World IMI HFRI Equity Hedge HFRI Fund of Funds Source: FactSet. *Calculated using composite net returns. Net returns are calculated by applying the management fee to the monthly gross returns of the accounts included in the composite. Shown as supplemental information only and complements the Global Market Neutral Composite presentation in the Appendix. 5

6 In contrast to the declines that equities experienced, fixed income returns were strong and defensive throughout the past seven years. They were buoyed by investor confidence in the stability of U.S. treasuries when panic set in, as well as by Federal Reserve policy that ultimately pushed interest rates to historically low levels. However, interest rates reversed in early 203, which provided an indication of how the LMCG GMN strategy would perform in a rising interest rate environment. Exhibit 7: The LMCG GMN strategy produced steady returns and exhibited low correlation relative to interest rates, during the first encounter with a rising interest rate environment. Composite Performance During a Rising Interest Rate Environment 04/30/203 to 2/3/203 Indexed Return Interest Rate (%) 4/3 5/3 6/3 7/3 8/3 9/3 0/3 /3 2/3 LMCG GMN (Net) U.S. Treasury 0 Year Yield Source: LMCG data using FactSet. Net returns are calculated by applying the management fee to the monthly gross returns of the accounts included in the composite. Past performance is not indicative of future results. Shown as supplemental information only and complements the Global Market Neutral Composite presentation in the Appendix. One measure of success of a liquid alternative absolute return investment lies in its diversifying characteristics in terms of correlation. Exhibit 8 shows that over the same timeframe, the correlation of the LMCG GMN strategy is impressively low relative to stocks and bonds. Exhibit 8: Since inception, the strategy has demonstrated low correlation to major equity and fixed income indices. LMCG GMN Correlation Matrix 04/0/2007-2/3/203 S&P 500 Russell 000 Russell Mid Cap Russell 2000 MSCI EAFE MSCI EAFE Small Cap MSCI Emerging Markets Barclays U.S. Govt/Credit Barclays High Yield Source: FactSet. Correlations are calculated using monthly gross returns since the strategy s inception to display the relationship between the composite returns and benchmark returns. The correlation coefficents range between + and -. A + implies perfect correlation, 0 implies no correlation and - implies perfect negative correlation. 6

7 WHY DELIVERING TREASURY BILLS +4% OVER LONG TIME PERIODS IS AN IMPORTANT OBJECTIVE The performance goal of the LMCG GMN strategy is to add 4%-5% above the returns of U.S. Treasury Bills (as represented by the CitiGroup 3-month T-Bill Index). This is an important hurdle to clear for the investment to be worthwhile for investors. As seen in Exhibit 9, Treasury Bills plus 4% has historically added value relative to the Barclays U.S. Government/Credit Index over long time horizons, without exposing the portfolio to extensive equity or credit and interest rate risk. Treasury Bills plus 4% will also outperform equity markets periodically. The strategy can be instrumental in helping to stabilize overall portfolio risk, and can be an extremely valuable tool for asset allocation when equities become overvalued. Exhibit 9: A target rate of Treasury Bills plus 4% has outperformed the core bond index. Cumulative Returns Return (%) Citigroup 3-Month T-Bill (Plus 4%) Barclays U.S. Govt/Credit Source: FactSet. The simulated performance returns for Citigroup 3-Month T-Bill (Plus 4%) were created by adding 4 percentage points to each calendar year return of the Citigroup 3-Month T-Bill Index. Subsequently, the returns were compounded on a cumulative basis. This time period was selected (January 995-December 203) based on the earliest available data from FactSet. Simulated performance results are shown only for illustration purposes and should not be considered representative of future returns and are inherently even less predictive of actual future performance than real-time model results or actual past performance. LMCG is willing to review and discuss the methodology of the simulation in greater detail, if requested. 7

8 Exhibit 0 is a performance comparison against the U.S. Equity Market Neutral Universe published by Lipper. Gross returns are utilized (for the strategy as well as the peer universe) in order to make fair comparisons ex-fees. Exhibit 0: The LMCG GMN Strategy versus the Lipper U.S. Equity Market Neutral Mutual Fund Universe. Since Inception As of 2/3/203 Yr 3 Yr 5 Yr 04/0/2007 LMCG GMN Composite (Gross)** LMCG GMN Composite (Net)*** Percentile ( Gross) Rank (Gross) 49 out of 82 out of 65 3 out of 4 out of 30 Source: Lipper. *The definition and additional details on rankings and statistical measures shown above are based on Lipper data and are available upon request. **Gross Performance is net of transaction costs as well as certain borrow costs and tax withholding on foreign dividends. ***Net returns are calculated by applying the management fee to the monthly gross returns of the accounts included in the composite. Shown as supplemental information only and complements the Global Market Neutral Composite presentation in the Appendix. Exhibit summarizes the risk characteristics of the strategy. Interest rate declines occurred during this period. For example, rates declined from nearly 5% (April 2007) to 2.7% (December 203), a scenario which is highly favorable to fixed income returns and unlikely to be repeated for some time. Exhibit : Risk Statistics Period: 04/0/2007-2/3/203 StdDev Beta* Correlation * Max Drawdown LMCG GMN Strategy Barclays U.S. Govt/Credit S&P Source: FactSet. Statistics of representative LMCG Market Neutral account. *Relative to S&P 500. Shown as supplemental information only and complements the Global Market Neutral Composite disclosure in the Appendix. 8

9 Exhibit 2: U.S. 0 Year Treasury Yield 03/07/984-03/07/ % 6.0% 4.0% 4.0% 2.0% 2.0% 0.0% 0.0% 8.0% 8.0% 6.0% 6.0% 4.0% 4.0% 2.0% % 0.0% Source: FactSet. 0.0% SUMMARY In general, alternative investments should be able to deliver strong absolute returns for a portfolio, while reducing the risk of declines during periods where traditional asset classes struggle. Many alternative strategies provide a variation of traditional asset classes through market timing or leverage of traditional returns. Others merely introduce different forms of beta: commodities like gold and other precious metals; oil; variations on debt high yield or emerging markets fixed income; subsets of equities REITs and MLPs. By comparison, the LMCG GMN strategy has been providing a source of return that is not a commodity, but is chiefly driven by the stock selection and risk management skill of a seasoned investment team and experienced operational support. Why does that matter? Many alternative betas may suffer similar fates as stocks and bonds during traditional economic declines. More traditional economic cycles involve overheating that creates poor bond markets and weak equity markets. Rising rates and declining growth may create poor alternative beta markets as well. Therefore, the need for real market neutral alternatives may be greater in the next market cycle than in the past period. Many investors believe that they should not pay for beta, which can be provided by any number of mutual funds and ETFs for very low cost. By significantly reducing the correlation to the equity market and bond market, successful market neutral returns will be comprised largely of pure alpha, which is valuable to investors over time and worth paying for. We believe the returns of the LMCG GMN strategy during the period have established this value. This material is presented for informational, educational and illustrative purposes only as the views and opinions of the author are not necessarily those of LMCG as a firm. 9

10 APPENDIX Performance As of 2/3/203 Q 4 Yr 3 Yr 5 Yr Since Inception 04/0/2007 LMCG GMN Composite (Gross)* LMCG GMN Composite (Net)** Citigroup 3-Month T-Bill Index LMCG GMN Excess Return over T-Bill Index (Gross) *Gross Performance is net of transaction costs as well as certain borrow costs and tax withholding on foreign dividends. ** Net returns are calculated by applying the management fee to the monthly gross returns of the accounts included in the composite. The Citigroup 3-Month T-Bill Index is an unmanaged index of three-month Treasury bills. Past performance is not indicative of future results. Shown as supplemental information only and complements the Global Market Neutral Composite. Global Market Neutral Composite Schedule of Annual Returns April, 2007 (date of inception) through December 3, 203 Gross Returns (%) Net Returns (%) Benchmark (%) Standard Deviation3 (bps) Composite 3yr Ex Post Standard Deviation (%) Benchmark 3yr Ex Post Standard Deviation (%) Number Of Accounts Comosite Assets at end of period ($ Millions) Total Firm Assets ($ Millions) Non-Fee Paying Assets (%) ,83.5 4, , ,42.7 4,365. 2, , Benchmark returns have been obtained from an independent source and have not been examined by independent accountants 2. Partial year return beginning April, Not measured in 2007 because of partial year. Not statistically significant in 2008 and beyond due to insufficient number of portfolios in the composite. Global Market Neutral Composite: Portfolios included in this composite are managed in the Global Market Neutral Strategy. The strategy seeks to outperform the Citigroup 3-month Treasury Bill Index through active stock selection by investing in small- and mid-cap stocks in the U.S. and mid- and large-cap stocks in non-u.s. markets. Long and short positions are dollar balanced to provide minimal equity market exposure and a low correlation to either the Russell 000 or MSCI EAFE indexes. Net exposure to beta, sector, market capitalization and country is targeted to be neutral. The strategy makes use of leverage (borrowing cash and securities). The gross market exposure of accounts in the composite may be up to 90% of equity. For comparison purposes, the composite is measured against the Citigroup 3-month T-bill Index. The composite was created in April Effective July 2009, the firm is defined for GIPS purposes as Lee Munder Capital Group, LLC ( LMCG ), an investment adviser registered with the Securities and Exchange Commission. In July 2009, LMCG became an affiliate of Convergent Capital, the Chicago-based diversified asset management holding company subsidiary of City National Corporation. Prior to July 2009, the firm was defined as Lee Munder Investments Ltd. ( LMIL ), a majority owned subsidiary of Lee Munder Capital Group and an investment adviser registered with the Securities and Exchange Commission. The firm maintains a complete list and description of composites, which is available upon request. On January, 203, the investment management fee schedule changed to.00% per annum on all assets in the strategy. Prior to January, 203, the investment management fee schedule was.25% per annum on all assets in the strategy. Actual investment advisory fees incurred by clients may vary. Results are based on fully discretionary accounts under management, including those accounts no longer with the firm. Account performance is calculated on a total return basis including income and realized and unrealized gains and losses. Gross returns are net of transaction costs, certain borrow costs and tax withholding on foreign dividends. Net returns are calculated by applying the investment management fee schedule noted above to the gross returns of the accounts included in the composite. The annual composite dispersion presented is an asset weighted standard deviation calculated for the accounts in the composite the entire year. The U.S. Dollar is the currency used to express performance. Policies for valuing portfolios, calculating performance, and preparing compliant presentations are available upon request. LMCG claims compliance with the Global Investment Performance Standards (GIPS ) and has prepared and presented this report in compliance with the GIPS standards. LMCG has been independently verified for the periods October, 2000 through June 30, 203. The verification report(s) is/are available upon request. Verification assesses whether () the firm has complied with all the composite construction requirements of the GIPS standards on a firm-wide basis and (2) the firm s policies and procedures are designed to calculate and present performance in compliance with the GIPS standards. Verification does not ensure the accuracy of any specific composite presentation. Past performance is not indicative of future results. 0

11 APPENDIX - GMN INVESTMENT TEAM MEMBERS Gordon A. Johnson, PhD, CFA Portfolio Manager Gordon Johnson is the lead portfolio manager for LMCG s International GMN strategies. Prior to joining LMCG in August 2006, Mr. Johnson spent six years at Evergreen Investments, where he served as senior portfolio manager and Senior Vice President/Director for the firm s Global Structured Products group. Mr. Johnson developed the department s domestic and international quantitative stock selection models and portfolio construction tools, and managed equity portfolios in the large-cap core, large-cap value, all-cap, small-cap core, small-cap growth, and EAFE asset classes. Prior to joining Evergreen, Mr. Johnson spent seven years at Colonial Management, where he served as portfolio manager for the Colonial Fund, a quantitative/fundamentally managed global mid-cap balanced fund and was Director and Vice President of Quantitative Research. He has also held teaching positions at the University of Massachusetts and California State University. Mr. Johnson is a graduate of California State University, holds an MBA from the University of Washington, Seattle and a PhD in Finance from the University of Massachusetts, Amherst. He is a CFA charterholder. Shannon M. Ericson, CFA, Portfolio Manager & Analyst Shannon Ericson is a portfolio manager and analyst for LMCG s International and GMN strategies. Prior to joining LMCG in August 2006, Ms. Ericson spent six years at Evergreen Investments Group, where she served as Vice President, Quantitative Equities Analyst for the firm s Global Structural Products group. Shannon s responsibilities included strategy design, new product development, and the rebalancing and optimization of portfolios. Prior to joining Evergreen, Ms. Ericson spent six years at Independence International Associates, Inc., where she served as Vice President, Quantitative International Equities and Marketing Officer, Quantitative International Equities. Prior to joining Independence International Associates, Inc., Ms. Ericson spent four years at Mellon Trust Company, where she served as Investment Communications Officer in the Private Asset Management Group. Ms. Ericson is a graduate of Bentley College and holds a BS in Finance and an MBA. She is a CFA charterholder. Vikram K. Srimurthy, PhD, CFA, Portfolio Manager & Analyst Vikram Srimurthy is a portfolio manager and analyst for LMCG s International and GMN strategies. Prior to joining the firm in August 2006, Mr. Srimurthy spent six years at Evergreen Investments, where he served as Vice President for the firm s Global Structured Products group and was primarily responsible for quantitative research and developing custom portfolio construction tools. Mr. Srimurthy has extensive experience with alpha models and quantitative research and development. Mr. Srimurthy is a graduate of Dartmouth College and holds a PhD in Mathematics from University of California, San Diego. He is a CFA charterholder. Daniel M. Getler, Analyst Daniel Getler is an analyst for LMCG s International and GMN Strategies. He joined the firm in May 200 as an Account Administrator in the Operations group. Mr. Getler joined the International Team in January 203 after working on several projects with the team. Prior to joining LMCG, Mr. Getler spent one year at Globe Tax Services, where he served as an International Tax Reclaim Specialist. Mr. Getler is a graduate of Oberlin College and holds an MS in Finance from Boston College. He is a level II CFA candidate.

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