In this article, we'll take a close look at market timing and how to measure it for managers who provide limited transparency.
There are very few hedge fund managers who tell investors market timing is part of their strategy. Despite the negative connotation of market timing since the 2003 mutual fund timing scandal, there is nothing inherently illegal about it. Long-only managers can time the market and profit by forecasting future market direction simply through changing their cash allocation. Hedge fund managers can do much more. Regardless of how they market their offerings, many of them respond to changes in market direction and their returns are greatly affected by that response.
The good news is that 96% of hedge fund managers provide enough data for their investors to tell how much they make from market timing. At Novus, we have a name for it: Net Exposure Management. Simply stated, it’s the value add from moving around net exposure.
We explored this, along with a few other portfolio management skills, in a recent article on how to analyze managers with limited transparency. In this article, we’ll look a little deeper into Net Exposure Management.
Paul Tudor Jones said it best: “I believe the very best money is made at the market turns. Everyone says you get killed trying to pick tops and bottoms, and you make all your money by playing the trend in the middle. Well for twelve years I have been missing the meat in the middle, but I have made a lot of money at tops and bottoms.”
If the consensus is against market timing, they’re probably onto something. In our analysis of hundreds of manager portfolios, we’ve seen very few that consistently benefit from market moves by actively timing net exposures. We’ll show you how our clients test their managers for this mythical skill in four charts.
First, you need to know the market the manager participates in and pick a good benchmark for the them. Let’s keep it simple with the S&P 1500 for a L/S manager who’s mainly US-focused.
Take the return of the benchmark:
And the manager’s net exposures over that time:
The manager changed their exposures meaningfully following the financial crisis in 2008, peaking at 108% net in 2011 and coming down to 40% net in 2014. Let’s tally the effect of these changes. First we take the manager’s average net exposure and multiply it by the benchmark’s return each month. Then we take their actual net exposure and multiply those by the benchmark performance. The difference in the two monthly times series is plotted below.
We can see, from the above chart, that the manager did well in decreasing their net exposures in 2008 and generated some alpha as the markets crashed. The following recovery wasn’t fully captured (see negative green bars) in 2009. Also, they ramped up their exposures at precisely the wrong time in 2011, taking a few very costly months and quickly reducing exposures once again.
Over the whole period, the cumulative net exposure management value-add looks like this:
The manager lost approximately 10pp from moving around net exposures vs. a scenario where they kept it perfectly flat. Not everyone can be Paul Tudor Jones. To learn more about timing the market, exposure management, and other skills you can identify in managers who provide limited transparency, read our latest report.