Recent analysis conducted at Cerno Capital reveals a positive correlation between the event driven hedge fund universe and the excess returns of smaller companies over larger companies. At the time of writing, we have observed meaningful outperformance of smaller capitalisation shares globally and some suggestions of an uplift in the fundamentals for event driven managers.

Event driven strategies exploit the informational inefficiencies resulting from corporate transactions. The term ‘event driven’ comprises a variety of strategies including merger arbitrage, special situations, restructurings and distressed events. As some managers seek to invest in a market neutral manner, in order for returns to be driven by corporate events rather than general market beta, it is said that event driven strategies exhibit a low correlation to equity and bond markets.

We have questioned this assumption. The environment most suitable to this strategy is that of economic stability and healthy corporate balance sheets, which inevitably leads to increased corporate activity as we have seen of late. Such an environment is also conducive to the performance of stocks in general. In particular, smaller companies may be benefitting more from exceptionally low interest rate policy and economic recovery.

Smaller business conditions have proven a reliable indicator for growth in the US and other developed markets. The impetus for our analysis was derived from the strong performance of smaller companies in the UK in 2013 and the backlog of IPOs of such firms. Many of them were not able to list during the financial crisis, but are now increasingly testing the market. More generally, smaller companies are attractive targets for larger companies. Organic top line growth might be difficult to achieve for those going forward, but this can be helped through strategic acquisitions; smaller companies are often the source of innovative technologies and products and offer the intellectual capital for larger companies to achieve faster growth.

To approximate returns from the wider event driven universe, we used the HFRX Event Driven index, mindful of its limitations due to survivorship bias; we compared the total returns achieved against the outperformance of smaller companies over larger companies on a global and regional basis over rolling 12 and 36 month periods.

Our analysis revealed that on available data since 1998, the correlation of the HFRX Event Driven index with the outperformance of the MSCI World Small index over the MSCI World Large index has been positive, at 0.39 over the period. The graph below illustrates the positive three year rolling correlation as the blue shaded area. The green lines are the three year annualised HFRX Event Driven returns and the three year annualised MSCI World Small over Large cap excess returns respectively. Over the past ten years, those have moved, more or less, in tandem.

Exhibit 1: 3 Year Rolling Correlation of the Global Event Driven Universe with the Excess Returns of Global Small Companies over Large Companies

chart 1a

Source: Cerno Capital, Bloomberg, HFRX

It would be a mistake to infer a stable relationship from such a short time series; however what strikes us is not only the positive correlation, but also the similarity of event driven and excess returns, on a global and regional basis, as illustrated below.

Exhibit 2: 12 Month Rolling Event Driven Returns and Regional Small Cap Excess Returns

Chart

Source: Cerno Capital, Bloomberg, HFRX

Ex ante, it is difficult to conclude whether, on this basis, it would be better to invest in event driven strategies or simply invest in a regional or global small cap ETF and selling a large cap ETF to extract the indicated excess returns. We can, however, conclude that event driven strategies on an aggregate basis have moved directionally, more or less, in tandem with smaller companies over the past ten years; however, the volatility of smaller companies has been higher both on the up and downside by approximately as much as the return achieved by event driven managers. This has interesting implications for multi asset investing and manager selection as this analysis has led us to seek managers who, we believe, have the ability to outperform the small cap premium.

 

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