Lyxor’s L/S Equity Neutral peer group was down -2.8% year-to-date, hurt by extreme trading conditions and the constituents’ average market beta of 20%. The environment has been challenging for the strategy amid extreme stock volatility and unsettling heavy systematic trading volumes. Moreover, market moves were largely driven by speculative factors – including the Covid-19 outbreak, stimulus decisions, a self-inflicted oil price war – the impact of which to be reflected with delay in macro and corporate statistics. As such, stock valuations were of poor relevance, with limited companies’ guidance and lagging analysts’ revisions. As a result, fundamental stock-picking approaches implemented in neutral strategies – such as DCF, financial ratio, equity risk premium or fundamental business analysis – worked poorly in long books. Additionally, while stock dispersion soared, theoretically opening relative opportunities, the very fast stock re-correlation (the absolute correlation of the S&P 500 stocks flirted with 0.8) forced neutral strategies to aggressively cut their leverage. All in all, the room for stock-picking alpha shrunk over the crash period. Instead, market timing and risk management were key differentiators.
We suspect that neutral portfolio buckets that focused on sector rotations, flow and liquidity arbitrage, statistical and high-frequency trading, and big data, outperformed.
Notwithstanding these challenging market conditions, L/S Neutral strategies benefitted from mitigating factors.
Unsurprisingly, they recorded positive contributions from their short books, even though short-selling was less profitable than in previous bear markets for reasons detailed in the following section. Neutral strategies’ elevated holding diversification also helped mitigate the surging stock correlation risk. Additionally, while volatility and dispersion across quantitative factors surged, their pairwise correlation remained moderate, allowing neutral strategies to navigate some of the obvious sector rotations (underperformance of consumer discretionary, energy, financial stocks vs. healthcare or staples). They generally suffered from their long value, short defensive, and quality positioning, but gained on their long momentum and short size holdings. While returns dispersion in our peer group spiked, we find that, on average, neutral strategies were down -5% over the crash episode and rebounded +2.5% after the bottom after March 23.
The sanitary phase of the outbreak is gradually coming at an end, with investors now increasingly focusing on the economic impact.
As a result, trading conditions are normalizing and the environment is becoming more fundamentally driven, in support for neutral strategies. Yet, the risk from another relapse in trading conditions relative to their moderate reward were markets to be past the trough for good, is unappealing in our view: we are U/W.
