Have you ever wondered what kind of exposures you’re getting from your equity market-neutral managers? As a strategy, equity market-neutral aims to provide uncorrelated returns (relative to the broad equity market) while delivering positive absolute returns over time. 

 

While these strategies are commonly offered by private hedge funds, they have also become prevalent in liquid alternatives (e.g., 1940 Act Funds and UCITS). More broadly, liquid alternatives have proliferated over the past decade, recently growing to $900B from $200B in 2008 (1). Given this growth, it begs the question, what exactly are mainstream investors getting exposure to when they invest in liquid alternatives? A recent Institutional Investor article raised similar questions, given the continued interest in private asset classes by these types of investors (2). Venn by Two Sigma can help investors seeking to explore these issues.

 

In this edition of the Factor InVe(nn)stigator, we analyze the liquid alternatives market by revisiting the very first post on Vennsights to review exhibit four, The Vanguard Market Neutral Fund (VMNIX). The fund, which seeks long-term capital appreciation while limiting exposure to general stock market risk, has lost nearly two thirds of its assets since our first post (3, 4). Maybe Venn’s Factor Analysis can shed some light on the fund’s performance.

 

Exhibit 1: Vanguard Market Neutral Fund I Factor Exposures (Summary)

Source: Venn as of 7/6/2020, October 20, 1998 - June 30, 2020, using daily data. 

Exhibit 1: Vanguard Market Neutral Fund I Factor Exposures (Summary)

 

 

Since inception (10/20/1998-6/30/2020), the fund has delivered an annualized 1.9% return with 7.8% volatility (3). As one might expect, beta to the Equity and Interest Rates factors is close to zero over the full period, and instead of broad market exposure, you can see the following positive style factor exposures. This is expected, as they are all long/short risk factors. 

 

Notable Positive Exposures:

  • Momentum: 0.36 beta (indicates exposure to stocks that have outperformed recently, funded by underperforming stocks)
  • Value: 0.24 beta (indicates exposure to stocks with low prices relative to accounting fundamentals and past prices, funded by higher-priced stocks)
  • Small Cap: 0.13 beta (indicates exposure to stocks with smaller market caps, funded by larger-cap stocks)
  • Quality: 0.12 beta (indicates exposure to exposure to stocks with low leverage, stable and high-quality earnings, and high profitability and investment quality, funded by lower-quality stocks)
  • Trend Following: 0.06 beta (indicates long-short exposure to multi-asset-class futures based on 6- to 12-month trailing returns)

Notable Negative Exposures:

  • Low Risk: -0.05 beta (indicates exposure to stocks with high market betas and residual return volatility)

 

Exhibit 2: Vanguard Market Neutral Fund I Factor Contributions to Risk (Summary)

Source: Venn as of 7/6/2020, October 20, 1998 - June 30, 2020, using daily data.

 

Exhibit 2: Vanguard Market Neutral Fund I Factor Contributions to Risk (Summary)

 

The positive exposure to Momentum was the factor that contributed most to the fund’s risk (26.30% factor contribution to risk). More importantly, though, the fund’s risk is predominantly unexplained using the Two Sigma Factor Lens, as seen by the 73.05% risk coming from the fund’s residual component. While large, this too is not unexpected for an equity market-neutral strategy that seeks uncorrelated returns.

 

In Exhibit 3, we investigate whether these key drivers of risk amounted to positive or negative contributions to return -- this is where the rubber meets the road.

 

Exhibit 3: Vanguard Market Neutral Fund I Factor Contributions to Return (Summary)

Source: Venn as of 7/6/2020, October 20, 1998 - June 30, 2020, using daily data.

Exhibit 3: Vanguard Market Neutral Fund I Factor Contributions to Return (Summary)



Looking at the fund’s factor contributions to return, we can see the following style factor exposures are indeed rewarded over the full time period.

 

Notable Positive Contributions to Return:

  • Momentum: positive 2.15% annualized return
  • Value: positive 0.61% annualized return
  • Small Cap: positive 0.02% annualized return 
  • Quality: positive 0.96% annualized return
  • Trend Following: positive 0.45% annualized return

 

However, we can also see the following exposures detracted from performance.

 

Notable Negative Contributions to Return:

  • Low Risk: -0.38% annualized return
  • Residual: -3.84% annualized return

This summary analysis appears to validate the fund’s approach to limit broad market exposure over the full time period, while highlighting the style factor exposures that largely contributed to the fund’s return. More importantly though, the analysis also illuminates significant performance concerns coming from the fund’s residual return. While the fund’s absolute return was positive, the negative residual return meaningfully undermined the gains generated by the common and well-known style factor exposures.


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To take this one step further, we can see how persistent these factor exposures and contributions to return are over the full time period. Below, Exhibit 4 shows Factor Exposures, while Exhibit 5 shows Factor Trend Contributions to Return, using rolling 3 year periods.

 

Exhibit 4: Vanguard Market Neutral Fund I Factor Exposures (Trend)

Source: Venn as of 7/6/2020, October 20, 1998 - June 30, 2020, using daily data.

 

Exhibit 4: Vanguard Market Neutral Fund I Factor Exposures (Trend)

 

Exhibit 5: Vanguard Market Neutral Fund I Factor Contributions to Return (Trend)

Source: Venn as of 7/6/2020, October 20, 1998 - June 30, 2020, using daily data.

Exhibit 5: Vanguard Market Neutral Fund I Factor Contributions to Return (Trend)

 

The consistent positive exposure to Momentum was rewarded (on average) over the full time period, despite a pair of episodes around the bursting of the Tech Bubble and the Global Financial Crisis where the Momentum factor underperformed. The exposure to Value was also consistently positive, and the full time period returns were positive as well (on average), overcoming the Value factor’s recent stretch of underperformance. The exposure to Quality was less consistent, starting off as a negative exposure, before turning positive towards the middle third of the period. Overall, the exposure to Quality appears to have led (on average) to positive returns.

 

On the other hand, residual consistently detracts from performance, with a few notable heavy periods as shown in dark orange towards the bottom of Exhibit 5. To further illustrate this, we can limit the analysis period to just the last 5 years as shown in Exhibit 6.

 

Exhibit 6: Vanguard Market Neutral Fund I Factor Contributions to Return (Trend)

Source: Venn as of 7/6/2020, June 30, 2015 - June 30, 2020, using daily data.

 

Exhibit 6: Vanguard Market Neutral Fund I Factor Contributions to Return (Trend)

 

More recently, the positive exposure to Value and the residual components seem to have very much detracted from the fund’s performance, erasing the gains coming from factor exposures like Momentum and Quality.

 

In summary, Venn’s Factor Analysis suggests that the Vanguard Market Neutral Fund I delivers on its objective to provide a return stream with little or no correlation to the equity or bond markets. However, it appears to have done so by providing investors with exposure to well-known and accessible risk factors, such as those in the Two Sigma Factor Lens, along with consistent and meaningful negative residual return. 

 

While private hedge funds focus on delivering positive residual returns over time, liquid alternatives may leave something more to be desired. As this analysis demonstrates, mainstream investors need to be careful in their evaluation and selection of liquid alternatives and should understand the types of exposures they’re getting as a result. Venn can be a helpful tool to do just that.

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If you have candidate investments for the next Factor InVe(nn)stigator, please send them to invennstigator@venn.twosigma.com

 

REFERENCES

1 Source: CAIA Association Report, The Next Decade of Alternative Investments: From Adolescence to Responsible Leadership - 2020, https://caia.org/next-decade

2 https://www.institutionalinvestor.com/article/b1l6q49zm3zk7d/Mainstream-Investors-Might-Get-Access-to-Alts-But-They-Won-t-Get-Alpha

3 https://investor.vanguard.com/mutual-funds/profile/VMNIX

4 https://www.morningstar.com/funds/xnas/vmnix/quote

 

This article is not an endorsement by Two Sigma Investor Solutions, LP or any of its affiliates (collectively, “Two Sigma”) of the topics discussed.  The views expressed above reflect those of the authors and are not necessarily the views of Two Sigma. This article (i) is only for informational and educational purposes, (ii) is not intended to provide, and should not be relied upon, for investment, accounting, legal or tax advice, and (iii) is not a recommendation as to any portfolio, allocation, strategy or investment.  This article is not an offer to sell or the solicitation of an offer to buy any securities or other instruments. This article is current as of the date of issuance (or any earlier date as referenced herein) and is subject to change without notice. The analytics or other services available on Venn change frequently and the content of this article should be expected to become outdated and less accurate over time.  Two Sigma has no obligation to update the article nor does Two Sigma make any express or implied warranties or representations as to its completeness or accuracy. This material uses some trademarks owned by entities other than Two Sigma purely for identification and comment as fair nominative use. That use does not imply any association with or endorsement of the other company by Two Sigma, or vice versa. See the end of the document for other important disclaimers and disclosures. Click here for other important disclaimers and disclosures.

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