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Pair Trades to Pare Risk

Thursday, April 06, 2017

In recent years, accessing the cheap beta of equity markets has been one of the best ways to invest. However, with dispersion becoming increasingly evident and potential political storm clouds gathering on the horizon, GAM portfolio managers Andy Kastner and Désirée Mueller ponder whether it might be a good time to reconsider a market neutral approach to investing in European equities.

All the early signs suggest that 2017 will see echoes of last year reverberating all over again. The beginning of 2016 proved a difficult period for equity markets, but the reasons for this were primarily related to risk-off sentiment among investors.

Commodity markets had fallen off a cliff and the slowdown in the Chinese economy suggested that prices could remain at rock bottom levels for an extended period. Investors naturally grew concerned that the malaise afflicting miners, the oil explorers/producers and their equipment suppliers could contaminate other sectors, potentially leading to a systemic collapse in equity prices.

Consequently, it is surprising to consider that we can now look back on 2016 as being a good year for stock markets, especially given the unexpected turmoil surrounding Brexit, the US election and the Italian ‘no’ vote. Indeed, with equity markets demonstrating an extra-ordinary sense of ‘bouncebackability’, 2016 once more suggested that accessing the cheap beta of passive funds was one of the best ways to invest.

Nevertheless, some of the misconceptions that have undoubtedly formed and invaded the psyche of investors since the era of the Global Financial Crisis could potentially lead to pitfalls in the period ahead.

First, in recent years, investors have effectively been taught that negative economic news flow is actually good for equity investment, simply because it allows central banks to continue to play the ‘lower for longer’ card. With central banks increasingly looking to begin the ‘normalisation’ process, it is time to revert to the concept of equities being supported by positive economic momentum.

Second, it is highly unusual for stock market beta to provide a persistent source of capital growth year after year. This scenario has occurred as a by-product of the ‘commoditisation’ of equity markets, which has been a direct result of central banking policies delivering an environment characterised by abundant liquidity, cheap capital and low volatility.

Third, it is really not a good idea to ignore corporate fundamentals simply because, in recent years, entire stock universes have tended to move in lock step in response to risk-on / risk-off sentiment gyrations referenced above. An extension of this argument draws the inference that dispersion is not in fact a rarely-observed phenomenon that is frequently referenced in history books.

One of the best ways to express relative conviction on individual stocks is through a ‘pairs trade’. In its simplest form, this involves taking a long position in one stock and an off-setting short position in an industry rival. Since this would effectively deliver neutrality at both the sector and the market level, the sole determinant of return is the relative performance of the two positions. If the share price of the stock in which a long position is held outperforms that of the shorted stock, a trading profit will be generated, regardless of the risks posed by adverse market movements and the relative fortunes of individual sectors.

While the trading of pairs remains one of the pillars of the EMN approach, strategies have typically become more sophisticated with the passage of time. Consequently, we are now able to ensure that neutrality is achieved not just at the market and sector level but also in terms of countries, currencies and investment style, by addressing this objective separately at the total portfolio level. This not only promotes a pure focus on security selection, but provides additional flexibility to express stock-level conviction, short or long, without the need to pair every individual trade.

The starting basis of our idea-generation process is a quant screen which ranks stocks in terms of fundamentals, valuations and momentum. We then undertake a qualitative assessment of the underlying business models in order to build an investment thesis. The portfolio is subsequently created as a function of stock-by-stock positioning, with the neutralisation of any residual risk exposures being the final component of the equation.

As we look ahead, we are optimistic about the potential to generate compelling returns from an EMN approach. Intra-sector return dispersions have been increasing for some months, partly driven by the so-called reflation trade, while markets appear remarkably calm given the geopolitical backdrop. If, as seems likely, volatility picks up in the period ahead, there is considerable potential for dispersion to widen further.

Given our commitment to remaining neutral at the market, country, currency, sector and style level, we are naturally insulated from a number of risks which could otherwise undermine the effectiveness of our stock selection. We therefore feel well equipped to face the uncertainties that lie ahead - perhaps it is a good time to be neutral?

Important legal information
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development.
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