K2 Absolute Return Fund

Long / Short Australian Shares Manager Review

PRODUCT

The K2 Australian Absolute Return Fund is a long-biased long/short Australian equity product managed with an absolute return focus. The investable universe comprises listed equities in Australia and New Zealand.

ORGANISATION

K2 Asset Management is an Australian based fund manager whose sole business is specialising in absolute return for retail, wholesale and institutional investors. The company was established in 1999 by Mark Newman and Campbell Neal. K2 Asset Management is wholly owned by K2 Asset Management Holdings Ltd which is a publicly listed company on the Australian Securities Exchange and is majority owned (92%) by directors and staff.

Investment Objective

The fund aims to preserve capital over the medium-term and generate a 15% per annum return, after fees, over a three to five year investment cycle.

Investment Philosophy and Style

K2 seeks to protect capital and produce absolute returns across different market cycles by investing both long and short in equity markets as well allocating to cash. K2’s investment team identifies catalysts for under and over valued companies based on three beliefs:

•  markets are inefficient

•  investment cycles are not uniform across global and regional markets at any one point in time

•  investment strategies need to be flexible to consistently perform in both established markets.

•  K2 aims to maintain flexible portfolios by primarily investing in markets and stocks that offer high liquidity.

Investment Strategy

The investment universe comprises all listed equities in Australia and New Zealand. The Manager seeks to preserve capital by typically implementing an average net market exposure of around 65% through a full market cycle. Where equity buying opportunities cannot be identified the default investment position of the Fund is cash, which reflects the opportunistic nature of the strategy.

K2 may utilise a broad range of strategies including short selling, derivatives and cash in order to adjust its net equity position in line with its market outlook. At various stages through the market cycle, performance may have a low correlation with traditional equity benchmarks.

Investment Process

K2 aims to profit from investments in both long and short positions. K2 employs a top down macroeconomic view with bottom up stock selection to identify under and overvalued stocks.

Macroeconomic analysis and the global strategy team determine the fund’s net equity exposure limits, guiding the proportion of long versus short positions. The exposure limits are discussed at weekly investment meetings, as are sector selection and style emphasis giving the underlying portfolio managers a clear understanding of the strategy team’s top down view. The fund has a long bias where net exposure has historically been 75%. The current position is over 85% representing the team’s positive market outlook. Gross exposure does not exceed 100% which is conservative compared with other long/short funds.

Following the determination of portfolio net equity exposure, five portfolio managers are entrusted to manage their own portfolios. Each is assigned a proportion of total capital based on experience and performance and has a high degree of autonomy in adding stocks to the fund. It is a deliberate decision to give each investment manager considerable discretion over their investment decisions. The portfolio managers each have different styles and areas of expertise which gives the portfolio the flexibility to exhibit different characteristics by altering the capital allocation between managers if market conditions dictate. Once a stock is included in the portfolio, positions are continuously monitored and reviewed, while strict risk management and stop loss guidelines apply.

The stock selection process is based on internal research, direct contact with company management and research provided by third parties. K2 seeks to identify those investments with some of the following characteristics:

•  Strong/weak earnings trend

•  Improving/deteriorating debt-to-equity ratios and improving/deteriorating debt servicing ratios

•  Under/overvalued securities relative to the sector and market

•  Securities trading at a discount/premium to their net tangible asset value

•  Entities likely to experience a rising/falling price-to earnings ratio

•  Beneficiaries/victims of a forecast change in the macro environment.

Portfolio Construction

Within the established net equity position of the fund, each of the five portfolio managers is allocated capital to invest and has the autonomy to research and pick stocks based on their own investment style and methodology.

The final portfolio is constructed in a benchmark unaware fashion by aggregating the individually managed portfolios. The stock investments are categorised into trade, core, high alpha and short positions –

•  Trade: reflects the manager’s short term expectations and are generated from any source within the macro economic view

•  Core: positions are more analysis-intensive and are afforded a longer time frame to achieve return targets

•  High alpha: positions are considered special situations where a higher level of risk is accepted with the expectation of a higher return

•  Short: positions are initiated based on stock specific events or momentum.

 PERFORMANCE 

* Inception date – 01 December 1999; ** S&P/ASX Small Ordinaries Accumulation Index

Despite underperforming its absolute benchmark, the fund has delivered strong returns in absolute terms over all periods to June 2011. Performance has been considerably higher than the S&P/ASX All Ordinaries Index for all periods, while the volatility of return has been consistently lower than the benchmark level.

COMMENT

The K2 investment team is well resourced to manage its Australian portfolio. Key management personnel hold extensive industry experience, and the team has an average of 6 years working together. Key person risk is centred on Mark Newman, whose macroeconomic views drive the fund’s net equity exposure. However, there is strong alignment of interest with a high level of staff equity ownership and co-investment in the funds, while portfolio managers receive a performance bonus determined by their contribution to fund performance.

K2's process combines top-down and bottom-up analysis and is well structured to deliver absolute returns in various market environments. There is no formal research framework (i.e. minimal standardised research templates, no single valuation methodology). However, all stock decisions are subject to peer review by the whole team.

The multiple portfolio manager approach provides diversification of styles and returns. Portfolio construction rules in place are sufficient to control potential individual stock risk within the portfolio.

The portfolio is actively traded which results in a high proportion of distributed income, including realised capital gains. Portfolio turnover is expected to be relatively high in the range of 500% p.a.

Performance over periods to June 2011 has been strong in absolute terms, significantly exceeding the S&P/ASX All Ords. Fees are above average.

The fund is an absolute return style long/short Australian equities product and is generally suited to an alternatives portion of a diversified investment portfolio.