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Portfolio Strategy

5 Essential Questions to Ask Asset Managers During a Bear Market

The SEI Novus℠ guide to data-backed conversations during turbulent markets: capturing alpha, liquidity profile, crowdedness, and structural changes.

Levi Branstetter
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Strong insights stem from asking the right questions. Investors can consider a bear market an opportunity to gain a deeper understanding of their managers’ skillsets, and even increase confidence in their allocations as a whole.  

We’ve collected 5 critical questions asset owners should consider asking their managers during a bear market—providing explanations of the questions, as well as points to look for in the manager’s answer.  

For users of The Novus Platform, we’ve also created a dashboard template to apply these analyses to either your portfolio, or your manager’s portfolio (given they provide transparency). The charts shared in this piece represent a sample of what you’ll find in the template. Simply click here or the button below to open the dashboard template.

Click “Use Template” in the upper right-hand corner of the dashboard, and apply your portfolio using the control panel.

Intrigued, but not an SEI Novus client, yet? Let’s chat.

1. Do you capture alpha on both sides of the book, in both an up-market and a down-market?

The ability to consistently generate alpha, in all markets, on both the long and short side, is a distinguishing characteristic of successful hedge funds. This idiosyncratic return source is a major reason investors allocate capital to the hedge fund space. When a manager can demonstrate this ability with persistence, they’ll be highly sought after.

Leveraging The Novus Platform to compare both the long and short books to a strategy-appropriate benchmark hierarchy can provide a clear framework for illustrating outperformance. Charts like the two illustrative examples below can demonstrate whether a manager is capable of adding tangible value, without depending on specific macro trends or overall market conditions.  

Hedge fund performance, alpha vs market returns for the long book
hedge fund performance, alpha vs. market returns for the short book
Figures 1 and 2: Blue represents the rolling 6-month alpha, and orange represents the rolling 6-month market returns. The chart type is included in our “Questions for a Bear Market” Template, available to clients of SEI Novus. Data shown in the above charts is from a paper portfolio created by SEI Novus for demonstration purposes only.

Analytics from our new template for clients (shown in Figures 1 and 2 above) can reveal a manager’s alpha versus market return on a 6-month rolling basis, over a variety of market conditions. Figure 1 shows the long book, and Figure 2, the short.  

For the purposes of this blog post, all charts from our template were run on a paper portfolio created by SEI Novus for demonstration purposes only.  

2. Were the areas in which you invested still accretive during this recent drawdown?

The unexpected happens. No one can predict the future. What we can do is measure the elements we have direct control over, such as category exposure and the resulting relative performance. In answering this question, managers can demonstrate that their portfolio is still generating returns in areas of expertise, even in a challenging market environment due to the active decision(s) of over/under weighted categories in combination with security selection alpha.    

Let’s break down the portfolio into sectors, so we can analyze how each sector performed during the drawdown.  

Average exposures by sector for hedge fund performance
Figure 3: Total return shown forInformation Technology (teal), Industrials (blue), Consumer Discretionary (green), and Communication Services (grey). The chart type is included in our “Questions for a Bear Market” Template, available to clients of SEI Novus. Data shown in the above charts is from a paper portfolio created by SEI Novus for demonstration purposes only.

Now, we can isolate one of the major sectors that were present during the drawdown to measure how it performed versus a sector-specific benchmark.

Sector vs category benchmark for hedge fund performance: informaton technologoy
Figure 4: Contribution shown for Information Technology (brown) and compared to the sector-specific benchmark (purple). The chart type is included in our “Questions for a Bear Market” Template, available to clients of SEI Novus. Data shown in the above charts is from a paper portfolio created by SEI Novus for demonstration purposes only.

Focusing in on the Information Technology sector shows that this sector's category benchmark also saw negative returns during this period—revealing that this sector  also faced a drawdown, albeit the performance was better than the benchmark.  

This same analysis can be replicated for the other sectors, as well as for other categorical breakdowns, such as market cap, geography, etc.

3. How does the liquidity profile of the book compare to non-bear market times?

Investors are unquestionably sensitive to liquidity.  

By comparing the liquidity profile to AUM over multiple market conditions, portfolio managers can demonstrate the presence or absence of a liquidity constraint as assets under management have fluctuated.

It’s important to note however that illiquidity can offer a premium at times (i.e., we often see a direct correlation between illiquidity and relative performance). As a result, managers may be able to showcase that seeking comparatively illiquid securities has been accretive in a challenging market environment.

During this analysis, it can be beneficial to look at average volume over a few different time periods (1 month, 3 months, 6 months) to ensure that a spike in volume over one or two trading days isn’t obscuring the result. Additionally, one could create a histogram of exposures using the percentage of exposures that can be exited over 1-5 days, 6-10 days, 11-20 days, etc.

Total AUM compared to 30 day liquidity for hedge fund performance
Figure 5: Blue represents the AUM and orange represents 30-day liquidity. AUM in millions on the left axis; liquidity on the right axis, meaning that x percentage can be liquidated in 30 days. The chart type is included in our “Questions for a Bear Market” Template, available to clients of SEI Novus. Data shown in the above charts is from a paper portfolio created by SEI Novus for demonstration purposes only.

4. How crowded are the names in your portfolio? Were you caught up in the trend of hedge funds de-risking and reducing exposure?

Crowding is a unique risk factor that only becomes apparent in certain market conditions. Investors need to understand how crowded their investments are to calibrate their understanding of how they could perform in a drawdown. Our research has shown that highly crowded securities can experience exacerbated drawdowns in periods of market stress, relative to less crowded securities.

There are three commonly-used ways to think about how crowded a name is.  

  1. Valuation – Big valuation suggests a lot of investors are paying up to own the investment.  This is a way to gauge how crowded the name is amongst the long only community.
  2. HF crowdedness — Look at both the number of managers invested in the stock and the liquidity of the hedge funds in each security (this is what the Novus Crowdedness Index measures).    
  3. Popularity amongst the sell side – What percentage of sell side analysts ratings are Buy or Overweight?

In a down market, bad news can result in downgrades, long only capitulation, and HF de-risking.

When hedge funds de-risk, they lower their total gross exposure—which means selling longs and covering shorts. If a portfolio is exposed to crowded longs or crowded shorts, then there will be pressure for the prices of the long book to go down and the short book to go up. And the short book may not provide the necessary amount of protection during a downturn.  

Analyzing the change in crowdedness over time compared to the overall portfolio performance and a selected benchmark (in this illustrative example, the S&P 500 Index) allows further examination, exploring whether the crowdedness of a portfolio had a noticeable impact on the overall portfolio performance and caused a divergence with the benchmark performance.  

average crowdedness compared to benchmark return (S&P 500) and performance
Figure 6: Changes in crowdedness (teal) over time compared to the overall portfolio performance (blue) and a selected benchmark (S&P 500 Index: green). Crowdedness average captured on the left axis, and performance captured on the right. The chart type is included in our “Questions for a Bear Market” Template, available to clients of SEI Novus. Data shown in the above charts is from a paper portfolio created by SEI Novus for demonstration purposes only.

Demonstrating an uncrowded portfolio could indicate that the manager is sourcing unique ideas compared to their hedge funds peers and won’t be caught scrambling for the exits when other hedge funds experience a liquidity crunch.

5. What, if any, structural changes have occurred because of the drawdown and/or flows?

Suppose a drawdown altered a key structural aspect of the portfolio (e.g., diversification / position sizing, effective market capitalization, liquidity profile). Now, an investor may no longer be investing in the same strategy that initially won them over. They may even feel the need to re-evaluate.

Looking at sturctural changes because of a drawdown
Figure 7: Comparison charts showing AUM against factors position count, market cap, concentration of top positions, liquidity, and crowdedness can reveal style drift associated with drawdown and outflows. This selection of charts is included in our “Questions for a Bear Market” Template, available to clients of SEI Novus. Data shown in the above charts is from a paper portfolio created by SEI Novus for demonstration purposes only.

Comparison charts such as the ones included in our new template will showcase how a portfolio has or has not changed during a drawdown; this can give investors confidence that a manager remains on top of style drift, and is continuing to steward capital towards their original investment objectives.

Portfolio Performance Analysis in a Bear Market

While some analyses remain valuable across all market conditions, savvy investors know just how to pivot their analyses based on the current state of the market. The accompanying template provides SEI Novus Users with a strong starting point for analyzing a manager's investments, or analyzing their own portfolio.  

This list is by no means exhaustive, and we will continue the coverage in a future blog post. Stay tuned.  

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.

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Learn how SEI Novus can help you.

Our team of world-class client management analysts will introduce you to our product, tailoring the conversation to your specific needs and interests.