Market neutral managers were anything but neutral in their performance during the wild market at the end of October.
Most managers interviewed outperformed their benchmarks, although a manager of a global portfolio got stung by the intense volatility.
The managers - even those who reported a loss - said the strategy that entails having a portfolio of long stocks and an equivalent amount of short stocks performed as expected in neutralizing the movements of the market.
"In the recent market turbulence, we got to see if the strategies that claim to be market neutral really are," said Donald H. Young, managing director in charge of the structured products group at Chancellor LGT Asset Management Inc., New York. "Market neutral managers haven't had a real test on the downside, only on the upside, until" last month, Mr. Young said.
Chancellor manages $600 million in market neutral, meaning its portfolios are $600 million long in stocks and $600 million short.
At Twin Capital Management Inc., McMurray, Pa., Geoffrey Gerber, president and chief investment officer, said, ".. . The value of our long stocks went up in accordance with the market and the value of our short stocks went down in accordance with the market. But we picked up little pieces of extra return. Our long stocks outperformed" slightly.
Indeed, two institutional clients Mr. Gerber wouldn't identify are increasing their allocations to Twin "because we did so well," he said. He acknowledged, however, the clients looked at a longer performance record than just the end of October.
Twin has about $60 million in its market neutral strategy.
Strategies work as designed
At First Quadrant L.P., Pasadena, Calif., David J. Leinweber, managing director, said, "We had a very good month" in October. "The market neutral strategies worked exactly as they were designed to work."
First Quadrant runs $1.7 billion in U.S. market neutral portfolios.
Said Theodore R. Aronson, CIO at Aronson + Partners, Philadelphia: "We're happy it performed well." Aronson has $50 million in market neutral.
At Analytic TSA Global Asset Management, Los Angeles, Bob Bannon, managing director, said, "We suffered from the volatility." Analytic TSA, unlike other market neutral managers interviewed, uses options and futures, rather than individual stocks, in its strategies.
"The difficulty is sharp market moves can be up or down," Mr. Bannon said, as they were on the record-setting final Monday and Tuesday of October. "Sharp market moves can imbalance an overlay very quickly."
Executives of pension funds that use market neutral strategies, such as Amoco Corp., Chicago, and ABB Inc., Stamford, Conn., declined to comment. Consultants familiar with the strategy also declined to comment or couldn't be reached.
Mr. Gerber said Twin Capital's market neutral strategy was down four basis points in the last week of October. For the month it was up 1.14% over the S&P 500. For the year to date, through Oct. 31, it was up 18.3% over the S&P 500, he said.
Its portfolios have about 90 to 100 stocks long and short.
Chancellor's Mr. Young said some clients were calling during the wild October week, inquiring about the strategy, while he and his team called other clients to inform them.
Chancellor's market neutral strategy was up 50 basis points over its cash benchmark, 90-day Treasury bills, for the first three days of the final week of October - including the Monday when the market fell a record 554 points.
The firm didn't have its returns available for the full week.
For the month of October, Mr. Young said the performance would be flat, or even, with the S&P 500.
Like most market neutral managers, Mr. Young said, "We hope to profit by stock selection using our model and to reduce all other sources of risk," especially market risk.
"Performance depends on the long-short spread, not the market," Mr. Young added.
Its typical portfolio contains 60 to 90 long stocks and 60 to 90 short stocks. "We want the (long and short) portfolios to look as much alike as possible."
How market neutral works
In general, market neutral strategies try to outperform cash, or 90-day Treasury bills. But that excess return, or alpha, is portable to any other portfolio. Typically, market neutral managers will overlay that alpha on equitized cash, that is, a synthetic S&P 500 portfolio, consisting of S&P 500 futures contracts. Under that strategy, market neutral managers hope the equitized cash outperforms the market.
"At times performance is negative because the stock selection model isn't perfect," Mr. Young said.
"The strategy doesn't work every day or every month or even every quarter."
On the day of the 554-point drop in the market, Mr. Aronson said his firm's market neutral's alpha was up 2.1%. "That's too high" for a day, Mr. Aronson said. "The next day 1.3% evaporated. That indicates how wacky the market has been."
The firm was up 70 basis points over its cash benchmark for the week. "That would be a good quarter," Mr. Aronson said.
At First Quadrant, Mr. Leinweber said the firm was up 1.7% over its cash benchmark, the day of the record point drop in the Dow Jones industrial average; for the month, up 3.4%; for year to date through Oct. 31, up 7.2%.
Global strategy hurt
At Analytic, Mr. Bannon said its global market neutral strategy was hurt by the market shock. "When it hit, we were long Hong Kong," he said. "That was painful. But it has come back in part."
The strategy invests in eight countries and uses only futures contracts. It uses exchange-traded contracts in stocks and bonds, as well as currencies.
In all, it typically holds all 22 possible asset classes, or three for each country except Hong Kong, which has no bond market and where Analytic TSA doesn't trade the currency.
Analytic TSA also has a market neutral strategy, using only U.S. options, both on individual stocks and stock indexes.
Both strategies were "moderately negative for October," Mr. Bannon said. "It wasn't a horrible month, but it was negative."
For the year to date, its global strategy is up 4% over the cash benchmark through the end of September. Its options strategy "had a rough year," Mr. Bannon added.
"It's down 4%. It's been struggling this year because it's net short volatility. But it's been a volatile year."
"There are two sides in every market: an option buyer and an option seller. If you sell volatility, you want it to hit a peak, but it's been continuing to go up. So it's been hard to make money."
Analytic TSA manages $200 million in each strategy.