5 Additional Questions to Ask Asset Managers During a Bear Market
The SEI Novus℠ guide to data-backed conversations during turbulent markets: full cycle returns, torque, covering shorts, weak pockets, inflation & IR.
Picking up where we left off in 5 Essential Questions to Ask Hedge Fund Managers in a Bear Market, we present 5 more critical questions to bring to your next meeting. Think of these as a supplementary list to our prior article.
Just like last time, you can follow along with our dashboard template if you are already an SEI Novus client. Run your portfolio, or the portfolio of a manager you’ve allocated to (assuming you receive transparency), against the 5 questions we explore below. Simply click here or the button below to open the dashboard template, hit “Use Template” in the upper right-hand corner, and set the portfolio for the dashboard using the control panel. Don’t have a login yet? Let's chat.
While this piece covers questions 6-10 from the dashboard template, you can find questions 1-5 here. For the full combined list (plus three bonus questions), check out 13 Questions to Ask Asset Managers During a Bear Market.
Note: All charts in this piece are included for illustrative purposes only.
6. Did you just give back all of your bull market outperformance in one market drawdown?
Suppose a portfolio does give back all of its outperformance in a market drawdown. This may indicate that one of the main factors of outperformance was selecting high beta stocks, which tend to outperform in up markets but underperform in drawdowns. Showing returns on a cumulative basis and comparing with a market benchmark informs whether prior outperformance disappears in a bear market. This concept is illustrated in the chart below.
Taking it a step further, we can also isolate the drawdown of the portfolio and compare against the drawdown of the market, depicted in the next chart.
If an investor cares about full-cycle returns (most do), then the investor would likely benefit from verifying that drawdowns show less correlation than gains. Everyone loves a 50% gain when the market gains 25%, but the good feeling fades fast if returns drop 50% when the market drops 25%. Investors might also consider the potential for loss aversion in this context—be wary of disproportionally valuing the fear of loss when compared with the opportunity for gains.
7. How exposed was your portfolio to the recent trend of inflation and rising interest rates?
These two macro trends have been the primary drivers of returns over a period of six months; therefore, being positively or negativity exposed to inflation or rising interest rates was a significant factor in over/under performance for active managers. Below we see the average monthly Risk-Free Rate against a fund's performance over the time period in question.
We can also analyze the portfolio's exposure to the recent trend of increased interest rates in the US. Below we've isolated the “Shift US” factor from our US Risk Factor Model, which represents the parallel shift in the U.S. Treasury curve.
If a portfolio is positively exposed to the US Treasury curve, this is commonly seen as a demonstration of future-proofing—which positions it to perform well in the current macro environment. Negative exposure might lead to questions regarding the investment strategies validity in this new environment.
Another valuable exercise is to look at fund exposure to sectors or industries with big growth expectations (like tech) as measured by lofty valuations. In a rising rate environment, growth tends to slow, and higher discount rates can push down the valuation of businesses in which the terminal value is an outsized portion of the overall valuation.
8. Does your short book have sufficient torque to withstand a deeper market drawdown?
Proving performance up-to-present isn’t a satisfactory answer here. Looking at position-level beta and overall market movement can provide an idea of how the short book will perform.
Comparing the drawdown alongside a short exposure time series gives an idea of whether the fund was proactive or reactive with its shorts during times of negative market performance.
Looking through an alternative lens, we can compare the net exposure to the beta adjusted net exposure over time. This takes the exposure of the portfolio to the broader market, and compares it with exposure that is adjusted based on the expected movement of each side of the book in relation to a given move in the market. Multiply the exposure of each position by its beta and sum to get beta adjusted exposure for both sides of the book.
A short book with low beta names tends to favor less protection, while a short book with high beta names favors more.
With the right tools to answer this question, we can demonstrate that the portfolio is ready for the subsequent drawdown, the manager has been proactive in managing their short book, and the manager is positioned to replenish the potential of the short book to outperform in an additional drawdown scenario.
9. How well do you manage exposures as shorts crack and need to be covered? Does your team have the bandwidth to refill the short funnel?
The following are two separate and essential skills:
- Having a good starting short book
- Managing and replenishing it during a drawdown
Investors want to know if managers are proactively managing the short exposure. Does the investment team have the internal capacity to replenish the portfolio with the same quality of short ideas as current shorts are covered?
This is an opportunity to demonstrate a portfolio’s robust research capability, as well as the team’s ability to consistently position investors into the best risk and reward positions.
The NASDAQ Composite (.IXIC:NASDAQ) at the time of writing has dropped -34% from peak (from June 2021 to June 2022). Such conditions can generate rapid short book turnover for hedge funds, with short trades working out and increasing the need for managers to rapidly initiate new positions.
We can look at the percentage of Short Exposure that is comprised of positions initiated in the last three months (as shown by the graph above.) This can provide insight into how quickly a manager can recycle covered shorts into fresh short ideas.
10. Are there any pockets of your portfolio that have been hit worse than others? Illiquid names? Specific themes? Geographies? Sectors?
The underlying intention behind this question is the following: Have losses been focused in a particular segment that is likely to reverse, or is the underperformance more systematic?
In order to identify these underperforming pockets, managers can compare active and passive contribution across various categories.
In the graph below, we see contribution broken out by liquidity bands. Each band groups positions by Days to Exit the position at 50% of normal volume. Illiquid positions seem to have held up particularly well, both active and passive contribution in the positive—the liquid side, not so much.
Isolating and explaining under-performance helps us feel more confident that a manager can self-reflect and correct any misallocation of capital going forward. It also gives the manager a chance to specifically explain why these same factors might lead to outperformance in the future if they choose to remain exposed.
Better Questions, Cleaner Answers
Modern-day investment tools make it possible for investors to have elevated conversations with their managers during a bear market. SEI Novus platform users can apply these questions to their own portfolios using this template. Not a client yet? Click here to request a demo.
To access our full list of 13 Questions to Ask Asset Managers During a Bear Market (including three bonus questions), fill out the form below.
For institutional investor use only. Not for public distribution. Charts included herein are for illustrative purpose only. Information provided by SEI through its affiliates and subsidiaries. This information is for educational purposes only and should not be considered investment advice. The strategies discussed herein are complex and are not suitable for all investors.