Karara Capital's market neutral strategy

Funds Management

by Jessica Amir

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Karara Capital Investment Manager Andrew Smith covers what’s new and exciting at the firm, what to expect with the Federal Election and provides insights into why its market agnostic strategy should be employed now. 

Jessica Amir:
Hello I’m Jessica Amir for the Finance News Network. Today I’m with Karara Capital Investment Manager, Andrew Smith. Andrew, welcome to the Network.

Andrew Smith: Hello, thank you.

Jessica Amir: For those that are unfamiliar, Karara Capital specialises in Australian equities. So what’s new and exciting at Karara in 2019?

Andrew Smith: Something that’s really exciting we’ve been working on for nearly three years now is our Market Neutral Fund. And we’re bringing that to market in a retail version that’s really exciting. These sorts of Funds are really new to Australia, they’ve only been around for about four or five years and there’s not many people in the competitive landscape. So we feel as though we’re leading edge and getting to market early.

Jessica Amir: Turning to the 2019 May election, what can investors expect?

Andrew Smith: We think there’ll be more uncertainty for investors. There’s three sort of categories that we’re concerned about. One is negative gearing, so the prospective changes; it’ll disrupt the market, so it could impact residential pricing to the lower side. And we’re also concerned about the prospect of implementation of the Hayne Royal Commission. So if you remember that’s to do with the banking. And if they force that too quickly, all of the changes may put pressure on the banks and they will in turn, lower the level of credit they’ll lend people.

So simply that means there’s not as much money available for mortgages. That puts further pressure on residential. So making these changes too quickly could really hurt the residential property market. The final thing we’re worried about is industrial relations, so that implies wage pressure. We’ve already seen this week Chemist Warehouse came out and had to increase wages by 20 per cent, over the next four years. And that might be a signal that things are about to come in the future.

Jessica Amir: Now to your investment offering Andrew, just walk us through your process.

Andrew Smith: Market Neutral is a bit different to other Funds. I need to explain straight away that for an example, $100 long and $100 short, means we’ve got no market exposure. So that’s interesting. The target of returns that we’re going for are somewhere between nine and 12 per cent. Importantly, the volatility that we’re looking for is only four to eight per cent. In context, the equity market’s 13 to 15 per cent, so it’s much lower volatility with very strong returns. We’ve been rated by Australian ratings as an approved product and also, our performance has been really strong.

Jessica Amir: Now can you just dive down a little bit more deeper into the Fund?

Andrew Smith: An example or a current position is long Spark Infrastructure (ASX:SKI) and short AusNet Services (ASX:AST). They’re both Australian electricity transportation and distribution companies. So they’re pretty much the same style of company and that’s what a pair is. Long one we like, short one we dislike. We only like and dislike based on relative valuation. So that changes. Another great example is Coles Group Limited (ASX:COL) versus Woolworths Group (ASX:WOW). Currently we’re long Coles and short Woolworths.

The principal reason is that the valuation differential is huge. Coles is trading on a forward multiple of 16 times and Woolworths is on 20 times. So there’s about a 20 per cent relative value differential and we think that’s wrong. So in this Fund, we’ve got the opportunity to go long Coles and short Woolworths. And as the shares move, we make the difference in between. And that’s in a nutshell, what a Market Neutral Fund does.

Jessica Amir: Changing pace now Andrew and turning to the US, we saw a key recession indicator rear its head for the first time since 2007. Just tell us what occurred and what it means?

Andrew Smith: There’s so many distractions going on, things like Brexit, Trump texts that come out in the middle of the night. But something we can hang our hat on, and it’s been proven in the past as a recession indicator, is a change in shape of the yield curve. In simple terms, the 10-year bond yield is normally higher than short-term bonds and that’s a normal curve. What’s happened is the long-term has declined and it’s actually gone lower than the near-term. And that’s historically been an indicator of recession. It’s not a guarantee and what we’ve looked at in our study is in general, it has to be negative for about three months.

And if that’s the case, a recession can come and equity markets treat that very harshly. In the last two times it’s happened, equity markets have fallen 50 per cent. Now I know that’s scary, it’s not necessarily what I’m saying, I’m just saying a warning sign has gone off. So for asset allocation decisions, it’s really critical at the moment to be careful of your equity exposure. And I might add a Market Neutral Fund, which doesn’t have any equity exposure, is really a nice place to be at this time in the cycle.

Jessica Amir: Just lastly before we let you go, anything to add today?

Andrew Smith: There have been two really surprising things going on in the market, probably in the last six to 12 months; it surprised a lot of professional investors. So not just normal mum and dad investors, I’m talking about guys who’ve been around 20 or 30 years. One of those is the phenomenon of high PE stocks momentum, versus low PE or value. That dispersion has gone out to the widest level it’s been since 1999; the tech boom, we know how that ended, it wasn’t very pleasant. So that’s occurring right now as we speak and it’s hurt a lot of performance from a lot of managers.

The other thing is people trying to predict bonds. And that’s why previously, we’ve spoken about the inverted yield curve, but predicting these curves is really problematic. You go back six months ago, many prominent Australian investors, who have long-term successful records, were saying the Australian bonds were going to go to 3.5 to 5.00 per cent. Now they’ve actually gone to 1.7, so work that out. It’s very hard to predict. So that’s why I fall back to the yield curve inversion being a real red flag for the equity market.

Jessica Amir: Andrew Smith from Karara, thank you so much for your time at the InterPrac Financial Planning PD Day.

Andrew Smith: Thanks for having me.