Can hedging your bets generate returns in all markets?

Up-and-coming hedge fund manager Omkar Joshi isn't fazed by two factors that to others in the field could be considered the Holy Grail of investment management: valuations, and the quality of a business. 

Instead, Joshi focuses on catalysts, that is, fundamental changes that could alter the pathway of a company's share price. 

So shareholders can benefit from these changes, both positive and negative, Joshi employs a "market neutral" strategy, hedging his holdings with an equal number of long and short position to generate returns in both bull and bear markets. 

This strategy appears to be working. The Opal Market Neutral Fund is up 21% after fees since inception in July 2020. This return hasn't piggy-backed on the broader rise in equity markets either, with its net exposure always close to zero. 

Even still, the founder of one of Australia's newest hedge funds has big shoes to fill. 

Prior to going out on his own, Joshi worked as the Sydney-based portfolio manager for Point72 Asset Management, having previously worked for Phil King at Regal Funds Management. 

For those not in the know, Point72's controversial founder, Steve Cohen, inspired the lead character of smash-hit series Billions (Bobby Axelrod) and also, just casually, owns the New York Mets. 

So is a "market neutral" approach the key to generating risk-adjusted returns in every market? Read the interview with Joshi below to find out. 

Fund at a glance: Opal Market Neutral Fund

Fund Manager: Omkar Joshi

• Asset class: Long/short Australian equities 
• Objective: The Fund aims to deliver consistent, absolute returns for investors with minimal correlation to equity markets coupled with low volatility and minimal drawdowns
• Minimum investment: $250,000
• Investment outlook: 3-5 years 
• Suitable for: Wholesale and sophisticated investors
• Launch date: July 2020
• Performance since inception: 21% net of all fees with almost no net market exposure
• Management fee: 1.38% p.a. (inclusive of GST net of any reduced input tax credits)
• Performance fee: 20.5% (inclusive of GST net of any reduced input tax credits) of the Fund’s outperformance above the benchmark, subject to a high watermark

Take us through how you built your fund from scratch to set it up for long-term success?

Opal Capital Management launched the Opal Market Neutral Fund in July 2020. It is a market-neutral fund, which means it has no net market exposure, with an equal amount of long and short positions. We also hedge out other factor, style and sector exposures, so that we are not taking any directional factor or macro bets and are focused purely on bottom-up fundamental stock selection. As a result, we don’t have any big skews in the portfolio, such as to growth or value.

We normally have about 20 to 30 long positions and the same number of short positions. We have found 40 to 60 positions in total is our sweet spot, and that is generally how we strike the balance between portfolio diversification and concentration.

Markets are either going up, down or sideways, but we’re focused on generating consistent, positive returns irrespective of market movements. 

Obviously, it’s not a guarantee; we are going to have down months as well. However, our disciplined focus on risk management means that we work to minimise any drawdowns and preserve capital for our investors.

It comes down to bottom-up stock selection; picking the right stocks that go up and the right stocks that go down, and that will generate returns for our investors.

For us, it is about being a slow and steady compounder. We basically target around 10% to 15% per annum after fees with minimal drawdowns and low volatility. It’s not just about the returns we generate, it’s also about the risk we take to generate those returns.

We generally try and hedge out some of the factor and style risks. For example, when we had the vaccine announcement in November, suddenly we saw value rallying and growth selling off quite aggressively. We like to be hedged out, so if we are long a growth name, we want to be short a growth name. The same goes for value. We will be long or short a stock for a fundamental reason, but we will generally have something on the other side to neutralise the unintended factor risks.

The same is true for bond yields, commodity prices, and even things like small, mid and large cap exposures. We don’t want a portfolio where all our longs are small caps and all our shorts are large caps, because then we have obviously got a very big beta skew in our portfolio. This would mean that if markets were to rally, we would do very well and if markets were to fall we would do very badly; however, our returns in both cases would have very little to do with our stock selection. That’s why we ensure our portfolio is well-balanced.

We can never hedge everything out because we have to take risks to generate returns, but we aim to hedge out unintended risks or skews when it comes to sectors, styles, and factors in our portfolio. At the end of the day, it’s all about individual stock selection for us.

What are the strategies and techniques that set you apart from other fund managers?

There are a few things we have seen in the past, such as the approach of buying cheap stocks and shorting expensive stocks. That might work for some investors, but at Opal, we absolutely don’t do that. 

For us, valuation is very much a supporting factor; we are not buying something because it’s cheap or selling it because it’s expensive. For us, it’s got to have something fundamental happening in the business - there has to be a catalyst, something changing. 

If valuation is in our favour, then that’s great. But we are never going to buy something because it’s cheap or short it because it’s expensive. This is definitely a point of difference for us.

Another point of difference is that some of the other long/short managers will buy good quality companies and short poor quality companies. That’s not something we are doing, because, for us, every company has got a price. It can be a terrible quality company, but if it’s at the right price, then we are very happy to buy it. The same goes for a really good quality company at the wrong price – we are very happy to short it. 

It’s more the realisation that, at the end of the day, share prices will eventually track earnings, making earnings the most important piece of information you can look at.

I came to this realisation after spending time looking at the drivers of stock movements and prices and found that earnings and catalysts were far more important than valuation and quality. For example, Qantas (ASX:QAN) was trading at $1.50 many years ago, and I wanted to buy it. However, my boss at the time said he didn't want to buy an airline because they are poor quality businesses. But the way I looked at the stock was that there were a number of fundamental improvements occurring in the industry and underlying business, and the stock was trading at book value. So whether it's a poor quality business or not, it was largely irrelevant because its earnings were going to improve. 

At Opal, the quality of the company or the valuation of the company absolutely does not drive a decision to either buy or sell the stock. 

Where are you seeing opportunities right now?

There's no obvious sector or theme that we are trying to currently profit from. That’s because we generally try and hedge these exposures out so we are not massively exposed to one sector or thematic, such as gold or reopening trades for example. For us, it's more about the outlook for individual stocks and obviously what's going on in the pandemic. There are lots of opportunities from that perspective.

CSR (ASX:CSR) is one that does stand out in the building materials space. It had quite a positive result earlier this week. They are leveraged primarily to bricks and plasterboard, which are seeing strong demand given the strength in the residential construction market. We have also had the HomeBuilder package which has been very positive for the industry, and will continue to be a tailwind given its recent extension. One of its peers, Brickworks (ASX:BKW), also released a positive result in recent weeks.

Another interesting opportunity is Genworth (ASX:GMA). It’s a mortgage insurer that had provisioned for a large increase in bad debts as a result of the pandemic. But the bad debts really have not materialised to the extent that we all expected. We have seen a similar situation with the banks as well - they all set aside large provisions last year and now they are starting to release those provisions. We will likely see a similar trend from Genworth as well over time.

Want to learn more about other newly launched funds?

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The interview is part of our Fresh Fundies series, focusing on newly launched funds (and their portfolio managers) with less than a three-year track record.

Over the next few weeks, we will be profiling:

• Jesse Moors and Nicholas Quinn, Spatium Capital
• Scott Williams, Fiftyone Capital
• Ben Rundle, Hayborough Investment Partners
• Michael Frazis, Frazis Capital Partners
• Emanuel Datt, Datt Capital
• Heath Behncke, Holon Global Investments

If you know of a newly launched fund that you think should be covered in this series - or if you are a portfolio manager who has recently launched a fund yourself - send us an email at content@livewiremarkets.com.

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