Smart Funds Appear to Be Surprisingly Defensive

The "Idiot’s Market Neutral Fund" 2008 report card
I first wrote about construction of an idiot’s market neutral fund about a year ago here and I further addressed the controversy of why the technique may work here. For the year 2008, this hypothetical strategy was down -0.7%. These returns are roughly in line with the HFRX Equity Market Neutral Index return of -1.2%. (Recall that this strategy goes long 5 Morningstar top rated, low cost and no-load large cap growth funds and 5 top rated value funds, called the smart fund sample, while shorting the S&P 500 Spyder (SPY) against the long positions.)

2008 was a tumultuous year and these returns are not bad considering the market environment the strategy had to contend with. The strategy had a good first half as the mid-year update showed that returns to June 30 was 3.5%. Given that the average annual turnover of the long portfolio was about 50% per annum, it was virtually impossible for any manager, even with good foresight, to outperform the market both in the first half and the second half of 2008. He would have had to be long the inflation bet in the first half and then switch to a low-beta bet in the second half. Indeed, the consensus sample of 20 large cap blend funds from the top mutual fund complexes, which usually perform in line with the market, underperformed by about 5% in 2008.

This strategy has also shown remarkably low turnover. Of the 10 funds in the portfolio, the strategy kept all of the growth funds and turned over only 3 of the value funds. Two value funds were taken out for style drift and only one was taken out for performance reasons.

What are smart funds doing now?
I reverse engineered the macro exposures of the smart fund sample, as well as the exposures of the consensus funds, and looked for significant differences. Smart funds show a surprising level of defensiveness considering the number of well-known investors who have turned bullish in the last few months.

As the chart below shows (click to enlarge), the estimate beta of the smart fund investors is significantly lower than the consensus:

Analyzing the exposure by sector, smart funds are underweight Financials (click to enlarge):

...and Energy (click to enlarge):

While smart funds are overweight traditionally defensive sectors such as Consumer Staples (click to enlarge):



…and Health Care (click to enlarge):

Surprising defensive readings
I find these readings surprising given the bullishness shown by investors like Ken Heebner (see his record here), John Neff, Warren Buffett, the ValueLine Survey, and many others too numerous to name. After all, the annual turnover of the smart fund sample is about 50% (as is the consensus fund sample) and these funds really don’t turn their portfolios around on a dime. So if these managers see value in the market, I would expect that they would start to be raising their beta exposures now.

Comments

[Jolly_Rancher:]

Be patient. The bottom is near, like maybe in the next 6 months. Things could get ugly. No good news on the horizon. Stay defensive. Why healthcare? Obama won't have the funds to gut it. Looks like the best bet. Why consumer staples? Obama increases transfer payments to poor. Smart fund allocation in these areas may not be so much a comment on the direction of the stock market, but an indication of political winds.

Hope you're having a great middle of the night.
Jolly Rancher

Jan 08 03:45 AM

[keithpiccir...:]

Another informative article, especially the insight in the first paragraph. The "Idiots Market Neutral Fund" could also appropriately be called the kiss principle.
I occasionally use ETF shorts as a pairs trade to parlay CGMFX, darting in and out of SKF and SRS when I read about great pain, and yes, sometimes my own.
Heebner's returns seem to have consistently underperformed the S & P 500 since mid November with CGMFX not gaining much ground on rising above the moving averages. He is not yet outperforming his peers.
CGMFX was in the bottom decile recently, a place he rarely visits.
Perhaps he has added other shielded positions as of last quarter besides WMT and MCD until he can see glimpses of a Phoenix type sector in the sunrise.
Clearly the bank financial play did not work, insurance was his latest dance, and he has lost his old Mojo. He must still have the gold and mining exposure and may add to it.
Weakened demand will equal lower earnings and lower stock prices across all sectors, making a focused fund even more challenging.
Transports and shippers in particular, with improving BDI index is the one I am watching but don't want to dock with the shipping stock without a chair when the music stops.
An informed trader type growth fund manager does not concern themselves with liquidity, yet one would think near term a heavier low beta exposure is the place to mend wounds until the slow and labourious opportunities present themselves.
Mid November marked a low that may yet be revisited in 2009, and big hulk funds are just not nimble enough to turn their frigates in time.
I tend to believe more in what Roubini and Marc Faber say to help keep my guard up.
In bear markets one should be basically neutral or bearish.
Thanks.

Jan 08 11:00 PM

[bsharvy:]

Seems kinda silly to me. The obvious "market neutral" benchmark is a CD, which returned 2-3% last year, handily beating anything discussed in this article.

Jan 09 04:06 AM

[E Nuff Sed:]

It is an decent attempt to capture the alpha and neutralizing beta. However I think you'd have to hold over long term 2 - 3 years at least to see a decent return.

Jan 11 10:48 PM