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Investment Structure of the Fund

WHAT IS A LONG / SHORT STRATEGY, AND HOW DOES IT WORK?

A long/short fund (as used by TAM) involves having approximately equal market value long (buy) and short (sell) portfolios. Long portfolios make money when the market rises, while short portfolios make money when the market falls. By having equal and offsetting long and short portfolios, the result is that there is minimal impact of market movements on the performance of the fund. Returns result from the price performance of the long portfolio being greater than the price performance of the short portfolio. The Fund also uses limited exposure gearing to add to returns.

The traditional way to make money investing in stocks is to buy shares and to sell them at a higher price in the future. This is referred to as being "long" stocks. With this strategy, there are two major factors in making money:

• The performance of the market; and
• The performance of the stock relative to the market.

Professional Funds managers have traditionally focused on trying to outperform the market via their stock selection processes (which is generally based on an estimate of value), and there has traditionally been little effort in forecasting markets. This is for the simple reason that there has been no real process developed for doing that, and the apparently irrational behaviour of world equity markets over the past year or so (and repeatedly in the past) helps to explain why that is.

As such, most equity Funds are effectively 100% invested in stocks at any point in time, leaving the view on markets to the investor: if you do not like the prospects for equities, you reduce your holding in the equity Fund. While this makes things easier for the Funds manager, it leaves the most difficult part of the investment management decision to those generally in the weakest position to do so: the investor.

By using a long/short structure, it is possible to effectively remove the prediction of markets from the performance of equity investment. The way that it works is as follows:

If a Funds manager’s stock selection process works in identifying stocks that will outperform the market, it should (for a particular universe of stocks that represent the market, such as the stocks in the ASX200) also identify stocks that will underperform the market as the value of the 200 stocks in the market index must equal the value of the market. Therefore, for every stock that is undervalued relative to the market, there must be a stock that is overvalued relative to the market.

Over the past few years, it has become possible to do the opposite of being "long" stocks: that is, being "short". This involves borrowing stock from long-term holders (mainly large institutions) for a small cost, selling that stock now to get cash, on the expectation that the price will fall so that it can be bought back at a lower price later in order to return the stock that was borrowed.

Therefore, if a Funds manager is able to select a portfolio of stocks that will outperform the market via his or her stock selection process, he or she should be equally able to select a portfolio of stocks that will underperform the market using the same process. If the two portfolios are of equal size, then the two offset each other as far as exposure to the market is concerned. If both portfolios perform in-line with the market, and the market rises, whatever profit is made from the Long Portfolio will be offset by losses from the Short Portfolio. Similarly, if the market falls, losses made from the Long Portfolio will be offset by profits made from the Short Portfolio.

The ability to make money from this strategy, therefore, relies on the ability to select portfolios that will consistently outperform the market both for a Long Portfolio and a Short Portfolio (Refer Appendix 2). In effect, profits are made whenever the stocks that are bought (that we are "long") perform better than the stocks that have been sold (that we are "short").

EXPOSURE GEARING

Under this strategy, the establishment of a short portfolio provides cash to Fund the long portfolio. As such, if it was possible to find someone who would lend the Fund unlimited stock, then it would be possible to establish an unlimited sized Fund without the need to put up any invested capital. Such a situation would clearly be commercially impractical (and dangerous). As such, the amount of stock that can be borrowed by any Fund at any point-in-time is controlled by the Fund’s prime broker, and is controlled by the amount of invested capital that is provided as a deposit to the broker. In the market at present, brokers are generally lending stock up to a market value of 4 times the Funds placed on deposit. However, a more average level is 2-3 times, and approximately 2 times is what will be used by the Fund.

To illustrate:

If the fund is able to achieve outperformance of 10% p.a. on the Long Portfolio, and 10% on the Short Portfolio, then total gains over a year would be $8m (10% x $40m + 10% x $40m). This gain would be achieved on the $20m invested, which equates to a 40% return (before fees and costs). If the outperformance by each portfolio falls to 5% p.a., the return to the fund falls to 20% for the year [(5%+5%) x 2].

Similarly, if both portfolios were to underperform by 5%, then the Fund would achieve a negative return of 20%.

However, it is possible for the structure to produce positive returns when one portfolio underperforms. If the Long Portfolio outperformed by 10%, and the Short Portfolio underperformed by 5%, then the net return to the Fund would be 10% for the year (5% net x 2).

Note: These are hypothetical examples used only to illustrate the structure employed, and does not represent any indication of future performance by the Fund.

The Titanium Asset Management Stock Valuation Process

The role of equity investment managers is to attempt to forecast the market price performance of listed stocks. Key to that process is the assumption that undervalued stocks will out-perform the market, while over-valued stocks will tend to underperform. As such, the valuation of listed stocks is the key stock-in-trade of managers. For that assumption to hold, any valuation methodology used must be linked to demonstrable share price behaviour.

A primary assumption employed by market participants is that:

Corporate value = Traded equity value = Share price performance.

Unfortunately, it has been effectively impossible to prove that link conclusively due to the variation in potential corporate valuation techniques, and a further assumption that markets can apply different valuation methodologies at different times.

Titanium, on the other hand, has looked to develop a valuation methodology that bypasses the corporate value = traded equity value assumption, and instead looks to employ a traded equity valuation methodology. This approach has two key differentiating features from the above assumption:

The valuation methodology is tested against actual market pricing of the ASX200 in terms of explaining both the absolute market prices, and variations in that price over time; a key test for any valuation model in order to prove its validity in explaining market behaviour;

The process values the traded equity rather than the underlying company in terms of expected total returns, and the appropriate discount rate implicitly applied by the market to those expected returns in order to set a price. Such a methodology captures the key potential pricing difference between listed and unlisted companies (the possibility of short-term capital gain expectations, which are not a potential factor in the pricing of unlisted stocks), as well as placing a major emphasis on the analysis and quantification of market perception and determinants of risk.

By using such a process, we have been able to explain in excess of 80% of the variation in the ASX200 price-earnings multiple since 1993, and the absolute level of that multiple. This proves that the above assumption does not hold, and that markets employ a significantly different valuation process from any corporate valuation process.

The process looks specifically at the key determinants of market expectations of future dividends and capital gains, and the time structure of those expectations implicit in market pricing, as well as variations in market equity risk premiums and the role of interest rates in market pricing. From here, the model is applied to sectors and individual stocks based on consensus earnings and dividend forecasts. A key control over the process is that the sum of the valuations of the stocks in the universe of stocks covered equals the overall valuation of the market proxy: in this case, the ASX200 index.

Key to the process is the analysis of market determinants of stock risk in explaining the spread of market pricing across the ASX200 universe of stocks. The process shows that major factors in the variation in the market pricing of risk include market capitalisation, trading volumes and volatility of the stock versus the market, cash flow generation, net debt-to-equity and interest cover levels, historical earnings performance, management performance (in terms of return on equity), etc.

By focusing on a valuation methodology that appears to directly explain market pricing behaviour, the process presents an opportunity to specifically forecast stock prices and returns; something that is effectively impossible using conventional techniques. This enables us to pick stocks (both to out-perform, as well as under-perform) more consistently than using other Fundamental techniques. In addition, market timing is enhanced by the use of consistently-applied market-relative trend indicators.

The process has been developed as part of doctoral study in Equity Market Pricing Theory, and the results of the analysis and its application to both the Australian and other major international markets is currently being reviewed for publication in a major peer-reviewed academic finance journal. In addition, it has been extensively tested and implemented over a 15 year period, both in the active management of institutional and high-net-worth Funds (on a cross-Asian basis) and for the selection of both long and short portfolios for the Australian market, producing substantial and consistent out-performance.

PORTFOLIO PERFORMANCE

Returns assume approximate equal weighting of stocks in the respective portfolios before transaction costs, while the Long/Short return assumes offsetting long and short exposures (market neutral) with 2x position gearing (no borrowing). This is the structure applicable to the Titanium Asset Management ASX200 All-Weather Fund.