With Markets on Edge, Traders Seek Independent Returns

Investment strategies hinging on the idiosyncrasies of smaller markets have the potential to offer investors an upside, even in the face of mounting anxiety over a global slowdown.

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In a time when money and data can be instantly beamed across the planet, there are still investments that are relatively immune from the churn of the global economy. That’s comforting news, given the uncertain global economic outlook: European growth remains weak on the eve of a potentially destructive ‘Brexit,’ developing world leaders like China and Brazil are mired in a slowdown, and in the US this month’s jobs report shows the most tepid job growth in five years.

But even in a flat and shrinking world where economic crisis and anxiety can hop borders every bit as quickly as capital and information, there are opportunities that remain relatively unimpacted by the prevailing chaos.

“The nice thing about market-independent strategies is that they can make money irrespective of whether equity and credit markets are going down,” says Michael Weinberg, an associate professor at Columbia Business School and chief investment strategist at Protege Partners.

Weinberg has studied market-independent strategies extensively throughout his career as an investor and analyst, which includes stints at Credit Suisse and Dean Witter, and memberships in the Economic Club of New York and the New York Society of Security Analysts. Technically speaking, these are “strategies that don’t derive their returns from traditional equity and credit market exposure,” Weinberg explains.

This is a counterintuitive concept, since traditional equity and credit markets have ripple effects that would seem to have a bearing on virtually any conceivable investment. As Weinberg explains, however, it’s still possible to invest on the periphery of more traditional markets, in areas where equity and credit have surprisingly little bearing.

One example is weather-influenced energy and electricity trading, where analysts use meteorological forecasts to anticipate changes in energy prices within markets that are disproportionately reliant on renewable sources, like solar and wind. Weather forecasts allow analysts to calculate the likely supply and demand of solar and wind — and the resulting effect on local energy prices. The 2015 El Niño, for example, dampened winds across the West, leading to a six percent decline in output even as installed capacity increased by nine percent. Reduced availability of renewables means greater demand for coal and, especially, natural gas, creating potentially lucrative opportunities.

A much different but still market-independent strategy is arbitrage of Chinese offshore and onshore bonds. Beijing’s market regulations require companies to list different securities for Chinese and foreign investors. This creates disparities in pricing that tuned-in investors can exploit. In April of 2015, mainland investors used their entire single-day investment quota of 10.5 billion yuan to purchase underpriced assets in Hong Kong after a bull run produced 92 percent gains in mainland markets while Hong Kong chalked up only 29.8 percent. China’s foreign currency markets allow for similar market-independent arbitrage opportunities: the onshore and offshore renminbi saw a record spread in January of 2016.

These strategies rely on factors that are often highly specific to individual industries within individual countries, and as a result they’re easy to overlook and often have only limited upside.

They’re also mostly clustered within developing markets, where lack of scale, lower competition from investors, and idiosyncratic regulations create inefficiencies that wouldn’t exist in more mature economies. “Emerging markets are inherently smaller markets,” Weinberg explains. “Because they’re generally not scalable, the markets tend to be too small for the larger funds. So there’s less competition, which means there are more inefficiencies.”

Scale represents the primary drawback of market-independent strategies. There’s money to be made on satellite reinsurance and weather forecasts — just not at the level that would attract billions of dollars of investment or create the potential for billions in returns. “These strategies can’t become too common because they’re generally heavily capacity constrained,” Weinberg says. Scale also tends to eliminate inefficiencies in a market. If the strategies were actually scalable, they might not exist in the first place.

These strategies are also based off of inefficiencies that the market could eliminate in the long run. “Inefficiencies are often exploited over time or arbitraged away,” says Weinberg. Market-independent opportunities are constantly appearing and disappearing: “One has to be on the ground and in the market and researching to find them,” he says.

At Protege Partners, Weinberg has helped identify hedge funds that are invested in these “capacity-constrained strategies.” Weinberg says that market-independent investments have achieved relative returns even during a time of uncertainty for equity and credit markets — the S&P 500 experienced a 14 percent decline between its March 2015 high and February of 2016 (though it had recuperated most of its losses as of June). Meanwhile, the selected market-independent hedge funds have been up over the same period.

As Weinberg makes clear, market-independent strategies have some inherent limits to them. But they operate at just enough scale to provide a potential backstop for certain types of investors—most notably pension funds, which have proven to be particularly vulnerable over the past decade of economic volatility. According to Weinberg, a portfolio invested in the strategies that Weinberg describes is better equipped to survive short, sharp contractions in equity and credit markets that are inevitable over the long run.

And that potential for turmoil never really goes away — even in times that seem relatively stable and prosperous, Weinberg stresses. “Here’s a question I ask my students,” Weinberg said. “How much do you think the S&P 500 was up from 2000 to 2013?” The answer, shockingly, is close to zero. Adjusted for inflation, the S&P has even seen a .01 percent decline between March of 2000 and today. Market-independent investment strategies might seem highly esoteric. But they can also have certain advantages over more traditional alternatives.

A downturn is always coming, eventually. But Weinberg’s work is a reminder that even a highly rationalized and efficient global economy has its gaps and that there are still ways around the vagaries of the market, regardless of how interconnected the global economy becomes.

About the researcher

Michael Weinberg

For more than two decades Michael has invested directly at the security level and indirectly as an asset allocator in traditional and alternative asset...

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