Download Staying Positive on Equity Market Neutral

Staying Positive
on Equity Market Neutral
Market Commentary
May 2017
KEY POINTS:
▪▪ Equity market neutral strategies are designed to leverage the benefits of
active equity management with limited exposure to equity market risk.
▪▪ Our investment approach establishes long and short positions in specific
stocks without relying on exotic derivatives.
▪▪ Equity market neutral strategies may be particularly compelling for investors
concerned about market downturns or rising interest rates.
What Is Equity Market Neutral?
Quite literally, equity market neutral (EMN) strategies invest in equities while
remaining neutral regarding the direction of the market. These strategies are designed
to generate returns regardless of how the broad equity market performs.
In practice, EMN portfolio managers combine long and short positions to generate
excess returns (alpha) while reducing exposure to market performance (beta). EMN
strategies are often referred to as absolute return strategies, since their returns rely
primarily on security selection independent of market returns.
There are a number of reasons investors might choose to invest in EMN strategies.
They may be appropriate for investors who are interested in:
Robert C. Doll, CFA
Senior Portfolio Manager,
Chief Equity Strategist
Nuveen Asset Management, LLC
▪▪ Taking advantage of the benefits of active equity management
▪▪ Earning returns beyond those available in bonds or cash
▪▪ Reducing interest rate risk
▪▪ Minimizing the negative effects of equity market downturns
Understanding Shorting and Leverage
Many investors have questions about how EMN portfolios are constructed and
how they actually work. Two investment concepts are critical to understanding
these strategies: shorting and leverage.
Simply put, shorting refers to selling a security at one price and repurchasing it at
another (hopefully lower) price. This is accomplished by borrowing the security, selling
it, repurchasing it and returning it to the lender. The difference between the sell and
buy prices represents the gain (or loss) from the transaction. It is important to
understand that costs and fees associated with shorting (including the security loan fee)
can potentially be substantial.
NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE VALUE
Scott M. Tonneson, CFA
Vice President,
Portfolio Manager
Nuveen Asset Management, LLC
Staying Positive on Equity Market Neutral
May 2017
Exhibit 1: Using Leverage in Equity Market Neutral Portfolios
Leverage is a form of borrowing that allows investors to use
one dollar to effectively invest more than a dollar. Leverage is
the amount of investment in excess of the actual capital invested
in a portfolio. This may sound complicated, but most people
use leverage every day. Consider a typical home mortgage. A
homeowner might buy a $500,000 house with $100,000 in cash
and take out a mortgage to pay for the rest. This homeowner is
using one dollar to invest in five dollars’ worth of home value. As
with shorting, leverage can also involve potentially substantial
costs and fees.
Sample Portfolio
Total Weight of Long Investments
90%
Total Weight of Short Investments
90%
Gross Weight / Leverage (Longs Plus Shorts)
180%
Net Weight (Longs Minus Shorts)
0%
For illustrative purposes only. Not intended to reflect the investment approach or actual holding of any specific strategy.
Our hypothetical EMN portfolio invests 90% of the total assets
in short positions. Since shorting involves selling borrowed
securities, additional cash is available to invest. The goal of an
EMN portfolio is to balance long and short positions. Therefore,
the manager uses the residual cash available from shorting
and also invests 90% of net assets in long positions for a gross
exposure of 180%.
Creating Value Through Shorting
So with that backdrop, let’s take a closer look at shorting.
Assume an EMN portfolio manager conducts research and
believes that a particular company will likely underperform the
broader market. Our hypothetical manager would then take a
negative (or short) position in the stock. If the value of the stock
falls, we would see a positive contribution to
performance. If the value rises, that would
detract from performance.
WE TRY TO ADD VALUE by relying
solely on our actively managed
Put another way, shorting companies
investment process: identifying
allows active equity managers like us to
individual securities we think look
take full advantage of research capabilities.
attractive and balancing those out
Using our firm as an example, Nuveen
with ones that appear unattractive.
Asset Management employs a large team
Net exposure is the critical data point
for EMN strategies, meaning the
weight of the long portfolio minus
the weight of the short portfolio.
EMN strategies strive for net market
exposures near 0%, which means they
have beta target near zero. EMN
strategies are designed to produce
alpha largely independent from market
beta. In other words, they are designed
as pure alpha strategies that seek
returns while minimizing exposure to the equity market. They
accomplish this objective by targeting a 0% (or close to 0%)
net exposure.
of talented quantitative and fundamental
research analysts. In the course of their
research, our analysts naturally identify
companies we believe will underperform the market. Shorting
provides the opportunity to add value by investing in an
underperformer.
In practice, beta targets for most EMN strategies tend to range
between slightly below zero and slightly above, depending on
the portfolio manager’s expectations for overall market prospects
and/or the weight of individual long and short positions.
Within an equity market neutral strategy, portfolios are
constructed to equally balance both longs and shorts so that
the overall portfolio has little actual exposure to changes in
equity markets. Understanding how that works leads us into a
discussion of leverage.
Our Approach to Managing
Equity Market Neutral Strategies
Using Leverage to Achieve Neutral
Positions
So with that background, how do we actually manage equity
market neutral strategies? It may be helpful to start with a
clarification of what we do not do.
There are multiple ways that portfolios can combine long
and short positions together into a single portfolio to achieve
different return and risk objectives, so let’s look at how an equity
market neutral strategy works.
Many EMN managers rely on swaps or other derivatives to add
leverage, balance long and short exposures or lower correlations
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Staying Positive on Equity Market Neutral
May 2017
to the broader market. They may also invest in sector-specific
exchange-traded funds (ETFs) to build their portfolios. These
approaches may have merit, but our approach is different. Our
pure play approach to portfolio construction means we only
invest in actual stocks: taking long positions when we think an
individual company will outperform and taking short positions
when we think a company will underperform.
While the past cannot perfectly predict the future, let’s consider
how equity market neutral strategies have performed during
previous equity market sell-offs. Over the past 20 years, the
S&P 500 Index declined more than 10% in 15 time periods.
EMN strategies significantly outperformed the broader market
on a relative basis in each period, although EMN performance
could still have been negative. In fact, while the S&P 500 Index
averaged a loss of 21%, EMN strategies actually gained 1.5%, as
shown in Exhibit 2.
Our alternative investing approach is an extension of our longonly investment process, designed to provide greater flexibility
to manage risks and generate returns. If our research identifies
a company we expect will underperform, we have the ability
to short it. At the same time, we can use leverage to purchase
or short companies, giving us an effectively greater than 100%
market exposure.
Exhibit 2: Reducing Equity Risk with EMN:
Performance When the S&P 500 Index Fell More Than 10%
 S&P 500  Morningstar US Fund Market Neutral Category
10%
Simply put, we try to add value by relying solely on our actively
managed investment process: identifying individual securities
we think look attractive and balancing those out with ones that
appear unattractive. We recognize that we are not experts in
investing in derivatives, employing swaps or selecting ETFs.
So we don’t use these tools. We are stock-pickers, so we build
portfolios by picking stocks.
0%
-10%
-20%
12/29/15 - 2/11/16
5/21/15 - 8/25/15
4/29/11 - 10/3/11
4/23/10 - 7/2/10
1/6/09 - 3/9/09
11/4/08 - 11/20/08
10/13/08 - 10/27/08
5/19/08 - 10/10/08
10/9/07 - 3/10/08
11/27/02 - 3/11/03
8/22/02 - 10/9/02
1/4/02 - 7/23/02
5/21/01 - 9/21/20
Shorting companies isn’t simply identifying companies we think
will decline in value due to bankruptcy or other challenges that
will result in absolute negative returns. Instead, we manage a
portfolio of short positions designed to underperform the overall
market. Our goal is for the long positions to outperform the
short positions, and the short positions to underperform the
broad market. In an up market, we seek long positions that rise
more than the market and short positions that rise less. In a
down market, we aim for the long positions to decline less than
the market and the shorts to decline more.
9/1/00 - 4/4/20
-40%
3/24/00 - 4/14/20
-30%
Data source: Morningstar Direct. Past performance is no guarantee of future results. Representative indices: Equities: S&P 500 Index; Equity Market Neutral: Morningstar U.S. Fund Market
Neutral Category. You cannot invest directly in an index.
EMN strategies may also be a compelling option for investors
concerned about rising rates. EMN strategies are often thought
of as bond market substitutes, as they are considered by investors
who want to put cash to work while limiting equity market risk.
Since we believe we are in a long-term trend of rising rates, it is
worth examining how EMN strategies have performed during
similar periods.
Ultimately, if our long positions outperform our short positions,
we are adding value.
Interest rates, as measured by the 10-year U.S. Treasury bond,
rose by more than 100 basis points on 9 occasions over the past
20 years. While bond markets declined during each period,
EMN strategies showed positive performance during six of the
nine periods. On average, bond markets fell 2.3% while EMN
strategies returned 1.6%.
If Markets Fall or Interest Rates Rise
Many investors are interested in EMN strategies to reduce
equity market exposure. By their nature, EMN strategies are
designed to minimize market risk, so investors concerned about
potential market downturns may be particularly interested.
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Staying Positive on Equity Market Neutral
May 2017
Exhibit 3: A Cushion Against Rising Rates:
Performance When Bond Yields Rose More Than 1%
 Barclays U.S. Aggregate Bond Index  Morningstar US Fund Market Neutral Category
6%
4%
2%
0%
-2%
7/8/16-12/16/16
5/1/13-12/31/13
10/7/10-2/8/11
12/30/08-6/10/09
6/2/05-6/28/06
6/13/03-6/14/04
11/7/01-4/1/02
10/5/98-1/20/00
-6%
1/18/96-6/12/96
-4%
Data source: Morningstar Direct. Past performance is no guarantee of future results. Representative indices: U.S. Bonds: Bloomberg Barclays U.S. Aggregate Bond Index; Equity Market Neutral: Morningstar U.S. Fund Market Neutral Category. You cannot
invest directly in an index.
What to Look for in Equity Market Neutral Strategies
Investors should consider several questions when selecting an EMN strategy. These
strategies can be complicated, and investment methodologies may vary greatly.
Specifically, we encourage investors to work with their financial advisors to confirm
the strategy’s potential maximum drawdown, how the strategy performed in different
market environments and the strategy’s beta exposure to understand why it is more or
less than zero.
Finally, investors should consider the same factors they analyze when selecting any
investment: the quality of the management team, whether the team has a sustainable
and repeatable process, the strategy’s track record and whether the investment team has
proven their ability to add value to the portfolios they manage.
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Staying Positive on Equity Market Neutral
May 2017
Robert C. Doll, CFA
Scott M. Tonneson, CFA
Senior Portfolio Manager, Chief Equity Strategist
Nuveen Asset Management, LLC
Vice President, Portfolio Manager
Nuveen Asset Management, LLC
Bob Doll is a senior portfolio manager and chief equity strategist at
Nuveen Asset Management. Bob manages the Large Cap Equity Series,
which includes traditional large cap equities, specialty categories and
alternative strategies. He is a highly-respected authority on the equities
markets among investors, advisors and the media. As the author of
widely-followed weekly commentaries and annual market predictions,
Bob provides ongoing, timely market perspectives.
Scott is a portfolio manager for the Nuveen Asset Management Large
Cap Equity Series, which includes traditional large cap equities, specialty
categories and alternative strategies.
Prior to joining Nuveen Asset Management, Bob held similar roles
at other large asset management firms, including serving as chief
equity strategist at Blackrock, president and chief investment officer
of Merrill Lynch Investment Managers and chief investment officer of
Oppenheimer Funds, Inc. He has 36 years of portfolio management
experience, received a B.S. in accounting and a B.A. in economics
from Lehigh University and an M.B.A. from the Wharton School of the
University of Pennsylvania. He is a Certified Public Accountant and holds
the Chartered Financial Analyst designation from the CFA Institute.
Bob appears regularly on CNBC, Bloomberg TV and Fox Business News
discussing the economy and markets. He has also been quoted in major
business publications such as The Wall Street Journal, Barron’s and
Financial Times.
Scott began working in the financial services industry in 1994 and
joined the firm in 2007. Prior to his current role, Scott served as the lead
fundamental research analyst for the Large Cap Equity Series and was a
senior quantitative research analyst responsible for building models to
deliver relevant quantitative data to the equity portfolio teams. Previously,
he worked at Ameriprise Financial as a quantitative equity analyst,
business analyst, and account analyst.
Scott received a B.A. in accounting from the University of St. Thomas
and an M.B.A. from the University of Minnesota’s Carlson School
of Management. He also holds the Chartered Financial Analyst
designation and is a member of the CFA Institute and the Chicago
Quantitative Alliance.
GLOSSARY
Alpha is the measure of the incremental return generated from active portfolio management.
Beta is a measure of the variability of the change in the share price for a fund in relation to
a change in the value of the fund’s market benchmark. Securities with betas higher than 1.0
have been, and are expected to be, more volatile than the benchmark; securities with betas
lower than 1.0 have been, and are expected to be, less volatile than the benchmark. The
Russell 1000® Index measures the performance of the large-cap segment of the U.S. equity
universe. It is a subset of the Russell 3000® Index and includes approximately 1000 of the
largest securities based on a combination of their market cap and current index membership.
The Russell 1000 represents approximately 92% of the U.S. market. The S&P 500® Index is
a capitalization-weighted index of 500 stocks designed to measure the performance of the
broad domestic economy. Bloomberg Barclays U.S. Aggregate Bond Index covers the
U.S. investment grade fixed rate bond market. The Morningstar US Fund Market Neutral
Category consists of funds that attempt to eliminate the risks of the market by holding 50% of
assets in long positions in stocks and 50% of assets in short positions.
RISKS AND OTHER IMPORTANT CONSIDERATIONS
This material is not intended to be a recommendation or investment advice, does not
constitute a solicitation to buy or sell securities, and is not provided in a fiduciary capacity. The
information provided does not take into account the specific objectives or circumstances of any
particular investor, or suggest any specific course of action. Investment decisions should be
made based on an investor’s objectives and circumstances and in consultation with his or her
advisors.
Investing involves risk; principle loss is possible. This information represents the opinion of
Nuveen Asset Management, LLC and is not intended to be a forecast of future events and
this is no guarantee of any future result. It is not intended to provide specific advice and
should not be considered investment advice of any kind. Information was obtained from third
party sources which we believe to be reliable but are not guaranteed as to their accuracy or
completeness. This report contains no recommendations to buy or sell specific securities or investment products. Prices of equity securities may change significantly over short or extended
periods of time. Alternative strategies sells securities that it has borrowed but does not own
(“short sales”), which is a speculative technique. A strategy will suffer a loss when the price of
a security that it holds long decreases or the price of a security that it has sold short increases.
Losses on short sales arise from increases in the value of the security sold short, and therefore
are theoretically unlimited. Because a strategy invests in both long and short equity positions,
the strategy has overall exposure to changes in value of equity securities that is far greater than
its net asset value. This may magnify gains and losses and increase the volatility of returns. In
addition, the use of short sales will increase expenses. All investments carry a certain degree of
risk, including possible loss principal and there is no assurance that an investment will provide
positive performance over any period of time. It is important to review your investment objectives, risk tolerance and liquidity needs before choosing an investment style or manager.
CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute.
Nuveen Asset Management, LLC is a registered investment adviser and an affiliate of Nuveen,
LLC.
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For more information, please consult with your financial advisor and visit nuveen.com.