Market neutral has proven a tough sector in which to produce outperformance but what are the main challenges and how are rated managers making the best of a bad situation?

Citywire Selector spoke to two leading lights operating in this specialist area to find out what had caused 2017 to be as tough as it was and where opportunities ahead may lie.

For Sycomore’s AA-rated Olivier Mollé, who runs the Sycomore L/S Market Neutral fund, it’s not just 2017 that has been challenging.

‘2016 was a difficult year for pure alpha generation - related to currency movements and a strong style rotation following the election of Donald Trump, 2017 is also unfortunately a complicated year,’ he told Citywire Selector.

Mollé (pictured) lost 0.74% in euro terms over the past 12 months, however the longer term picture is rosier, as over three years he returned 7.09% in comparison to the average manager of just 3.60%.

‘Global growth is meeting expectations. It has allowed stocks with a well-diversified geographical revenue mix to display good performance. However, the weakness of inflation and interest rates has created a significant sector performance and valuation disparities.’

Overall, Mollé said the equity market has become very excessive on valuations, led by the general feeling that interest rates will permanently remain at low levels due to central banks’ accommodating policies.

‘Conversely, the market is highly severe with stocks containing uncertainties. This very radical environment makes pure alpha generation very complicated in a flow driven market, invested in trends by passive funds, in a world that has forgotten the concept of risk.

‘I think 2018 will continue to be carried by global growth but global GDP dynamism in the absence of inflation can only deteriorate. Indeed, the historical gap between growth and inflation could tighten and certainly lead to a repricing of risk which may surprise investors and penalise, at least temporarily, risky markets.’

Forecasters forewarned

Citywire AA-rated Ian Heslop, who co-runs the Old Mutual Global Equity Absolute Return fund in the market neutral sector, said the ability to create uncorrelated returns is an age-old problem in the sector and became apparent in 2017.

‘This may seem counter intuitive but, even with perfect market neutral portfolio construction; the presence of styles within a portfolio can lead to correlation. Our argument is this is the very thing investors wish to avoid in the first place when allocating to market neutral funds.’

Heslop said forecasters should steer clear of this area of investment, because even if you can correctly guess GDP growth or rate hikes, quantifying the market response is a much tougher task. In addition, you could be hit by a sudden style shift.

‘This year has been one of huge style rotation and, as we always say, the diversified nature of our investment process has been a major contributor to the performance and the distinct lack of correlation achieved.

‘It has also been very important to have a dynamic way to adjust fund style exposures to ensure the portfolio remains correctly set even as the market changes underneath it. Getting that right has been the major driver of returns this year.’