The long and short of an absolute return fund

-- | 24/03/2021

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Lex Hall: Hi, I'm Lex Hall for Morningstar. The Bennelong Kardinia Absolute Return Fund outpaced the market by a pretty healthy margin last year, so I thought I'd catch up with one of its portfolio managers, Kristiaan Rehder, to talk about strategy, to talk about performance and of course, to talk about what lies ahead.

Hi, Kristiaan. Welcome to Morningstar. Thanks for joining us.

Kristiaan Rehder: Hi, Lex. Thanks for having me on your program.

Hall: Not at all. Now, in the past year, the fund returned 6.72 per cent versus 2.23 per cent, which comprises the RBA cash rate plus 2 per cent and since inception in May 2006, it's returned 8.83 per cent, which compares to 3.36 per cent. How does a fund—how do you beat the market like that? Is that what an absolute return fund does, it beats the market in all weather?

Rehder: Well, we're an absolute return fund. So, we're slightly different, I can imagine, to many of your guests on your podcast.

Hall: Sure.

Rehder: An absolute return fund that has the ability to go long and short. In the old world, we were kind of referred to as a hedge fund. These days, we like to refer to ourselves an absolute return fund. And just to take one step back just for the background knowledge of your audience, when I think about absolute return funds in the Australian context, I really see absolute return fund sitting in three main buckets. The first bucket is market neutral. They manage their net exposure to around zero and they do that by entering in a pair trade. So, they will typically go long a stock in a particular sector, usually the highest-quality name they can find, and they'll go short the lowest-quality name in that same sector. And then, they'll apply a healthy dose of leverage, so they can use 5 to 6 times’ leverage, it's not uncommon, to magnify those returns.

And active extension is the second bucket. It's like a 120/20 or 130/30 fund. They don't manage their net exposure to zero. In their case, they manage their exposure to 100 per cent and they do that by fully investing in their long book and then selling short; in the case of a 120/20 fund, 20 per cent of that fund short and they will receive short sale proceeds when they sell those shares, and they will use that 20 per cent at the end if they want to push their long book up to 120 per cent. So, their long book becomes 120 per cent, 20 per cent short. They basically set their net exposure over 100 per cent.

The way I think about an active extension strategy is very much a bull market strategy. If you're very confident the market is going to go up and you want leverage to that, then it's not a bad place to be. We're a variable beta strategy. So, we don't manage our exposure to 100 per cent of our net exposure to 0. We have the flexibility within our mandate to vary it depending on how bullish or bearish we are. So, that's kind of the way we think about our portfolio. It's probably very similar to the way anyone manages their own personal portfolio. If they're bullish, they will apply more money to the market. If they're bearish, they will liquidate their positions and go to cash.

The interesting thing about Kardinia is we've been going for 14 years. So, we're one of the longest established absolute return funds out there. The nice thing about having a 14-year track record is that we've seen both bull markets and bear markets. The strategy has certainly been tested. We're very conservative. We limit our net exposure to 75 per cent. We've don't use leverage. We're very disciplined stock (indiscernible) in place. But what that actually means is that we have lower volatility than the underlying markets. So, our volatility sits around 7 per cent; the underlying market is around 15 per cent.

Hall: So, who, Kristiaan, have been sort of the big performers in short for your fund?

Rehder: Look, we kind of approach our shorts the same way as our longs. We get I think a lot of questions about our shorting because it's something which I think many people are intrigued about, have much familiarity with. (Lots of the) absolute return funds treat their shorts in different ways. As far as the Kardinia Capital is concerned, we treat our shorts as a profit centre. They need to make money for us. We approach our shorts exactly the same way as we approach our longs.

So, what does that mean? Well, we're often looking for not winning stocks as such. On the long book, we're looking for winning stock attributes. And so, some of the attributes we're looking for is we're looking for businesses with a strong balance sheet. We're looking for businesses that have high returns returning businesses. We're looking for businesses that are operating within the industry that tends to be growing. And then, if the company can demonstrate market share growth within a growing industry, then you get the double leverage effect. We're also looking for companies that operate in large, total addressable market sizes as well.

Now, on the shorting side, it's the complete opposite of that. When long-only manage is, kind of, come across the company and they identify a number of red flags, they typically put their pens down and walk away, and that's the end of their analysis. For us, we can kind of extend that analysis, complete it, and then we can take one step further and actually profit off it by going short. So, we're looking for companies that have very weak balance sheets. We're looking for companies that are operating in industries that are declining, with declining earnings and margins, poor cash flow. They are the kind of businesses we target.

Hall: One word on your holdings. NAB is the biggest holding. Can you tell me why that's the biggest? Is there something people are missing there? Or what you're seeing that others aren't?

Rehder: Well, it's quite interesting. If you look back over the last five years, we were basically naked banks. We actually were shorting a number of the banks and we made quite a good money off it. I can reveal that we were short Adelaide Bendigo Bank for some time. We've now closed out that short. But if you look back over the last five years, it was almost a perfect storm for the banks. You had the royal commission, which the banks, obviously, didn't shroud themselves in, in much glory. You had the RBA cash rate continued to climb and that applied significant pressure on the banks' margins. You also had COVID coming into the mix. You had restrictions on credit with responsible lending changes, and that all culminated in a very tough operating environment for the major banks.

Now, if you look at all those issues now and you want to clock forward to today, you will find, I think, that a lot of those headwinds have now become tailwinds. So, the balance sheets of consumers are much stronger than I think what people anticipated last year. So, we're really seeing a situation where margins for the first time in a while is starting to come back. The balance sheets are particularly strong and well-capitalised. We think in the next 12 months, you're going to start to see capital return by way of buybacks and the reinstatement of dividends from the banks, which I think will be—will put them in pretty good stead for next year.

Hall: OK. Well, you, kind of, anticipated, Kristiaan my—I was going to ask you—or remind you rather—that six months ago you said you were “reasonably cautiously optimistic”. So, I suppose we can remove the reasonably and the cautiously from that?

Rehder: Yeah, that's right. We are optimistic. I mean, it's interesting. I read recently that the pandemic will be over in 100 days and we have been watching the global statistics incredibly closely. And I have to say it does sound counter-consensus at the moment, but I tend to agree. If you look at all the statistics globally that are occurring, we now have inoculated only 4 per cent of the global population, but some countries are doing better than others and a great country to look at is obviously Israel. They've vaccinated around 55 per cent of their population with their first dose. The insignia about Israel is that it's a large sample size and they are vaccinating quickly, and you can see in real time the results of that vaccination program and all the key statistics have been incredibly positive. So, the COVID death rates have fallen well down, serious symptoms are down. It's almost a 99 per cent success rate based on those measures as far as we can see.

The US, it has been a slow start, but it's getting there. Mid to low 20 per cent of their population has been vaccinated. The UK is around 35 per cent. If you do look at the capital markets, look at equity markets and debt markets, it is pretty clear that they're looking through this virus already and they are more firmly focused on stronger growth that's coming down the pipeline, inflation and then the steepening yield curve.

Hall: OK. And finally, Kristiaan, in your update you also talk about copper. What's the significance of this and why are you bullish on it? What should investors know about that?

Rehder: Well, look, copper is an interesting commodity. We think there's been a lot of underinvestment of copper for some time. And it's not just copper. A lot of the base metal commodities have also suffered from underinvestment. You've had a particular spike, I guess, in copper. I think it's 15 per cent up this month alone. It was up around 85 per cent since March of 2020. So, it's had a decent spike. I think what's driving the price growth in copper has been just the return of demands. And so, you're seeing global economies really starting to accelerate in terms of growth. You've seen the industrial production base of the US and China really springing back to where it was and now, even beyond where it was. I would also say that in this world of decarbonisation and the electrification of power, it's going to require a tremendous amount of copper, and we simply don't think there's enough copper out there to satisfy the demand.

This report appeared on 2021 Morningstar Australasia Pty Limited

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