Stockholm (HedgeNordic) – The normalization of interest rates is expected to induce dispersion among stocks, thereby creating a more favorable environment for stock pickers on both the long and short sides. In theory, this sets the stage for an advantageous environment for equity market-neutral strategies. The same normalization of interest rates enhances the return potential for such strategies, given their cash-rich portfolio enabled by the financing of long positions through proceeds from short sales. PO Nilsson, who has managed equity market-neutral fund PriorNilsson Yield since late 2002, argues that this market environment represents one of the most optimal for such strategies.

Instead of being determined by the direction of markets, the performance of market-neutral strategies is influenced by factors such as stock-picking skill, short-term interest rates, and the level of dispersion among stock returns. “Just a couple of months ago, when interest rates were virtually zero, achieving returns significantly higher than the short-term rates as an equity market-neutral investor was challenging,” asserts Nilsson. “At the same time, the current volatility in the stock market is healthier and can offer more interesting and diverse investment ideas compared to the environment of zero interest rates,” he continues. “This prevailing environment is much better for both our return sources.”

“Our goal is to achieve a return of six percent or higher in a year like this one, where interest rates stand at four percent. Investors should broadly have a general understanding of the fund’s day-to-day behavior.”

PriorNilsson Yield aims to serve as an alternative to cash or bank deposits by targeting returns ranging between two and four percent above the risk-free rate offered by short-term certificates. “Our goal is to achieve a return of six percent or higher in a year like this one, where interest rates stand at four percent,” explains Nilsson. Setting the return objective aside, PriorNilsson Yield is designed to be a ‘risk-averse’ investment option, aiming to provide investors “a decent return without any major risk,” according to Nilsson. “Investors should broadly have a general understanding of the fund’s day-to-day behavior. They shouldn’t be concerned about a huge gain or loss overnight. This is a product that allows investors to have a clear understanding of what their investment is worth at any given time.”

The ‘Yield’ Component of PriorNilsson Yield

Given that long positions are largely financed by short sales, market-neutral strategies typically maintain a significant portion of their assets in cash, often allocated to fixed-income instruments. Consequently, a rise in interest rates can amplify absolute returns for most market-neutral strategies. To accommodate portfolio rebalancing, PriorNilsson Yield retains approximately eight percent of its net assets uninvested, with the remaining cash deployed across short-term government bonds (around ten percent), short-term corporate bonds with maturities of up to a year (40 percent), and company certificates with maturities ranging from one month to one year. “We aim to create a diverse mix of these instruments across a huge number of different positions, with none of them holding a sizeable share of the portfolio,” explains Nilsson.

“We try to diversify exposure within a credit portfolio as much as possible to different sectors, mitigating the risk of overexposure to any particular sector, such as the dominant Swedish real estate sector, for example.”

“It doesn’t matter if we encounter issues with a single investment at any given time, which hasn’t been the case so far in our 22 years of investing,” says Nilsson. Nevertheless, PriorNilsson Yield strives to maintain a portfolio size ranging between 40 to 60 positions to minimize individual risk. “We try to diversify exposure within a credit portfolio as much as possible to different sectors, mitigating the risk of overexposure to any particular sector, such as the dominant Swedish real estate sector, for example,” notes Nilsson. While the credit risk associated with PriorNilsson Yield’s fixed-income investments remains very low, the primary risk arises from sporadic bouts of illiquidity in the market.

“We have not experienced any credit defaults or incurred any losses throughout our entire journey of 22 years,” asserts Nilsson. “However, we have encountered occasional pricing irritations due to illiquidity,” he adds. Nilsson’s colleague, real estate-focused portfolio manager Gustav Sällberg, assumes responsibility for managing and overseeing Yield’s credit portfolio. “Gustav and I collaborate closely on credit market-related investments. However, I handle the bulk of the work related to the stock market,” notes Nilsson.

The Spread Between Longs and Shorts

The equity market-neutral strategy employed by PriorNilsson Yield serves as an additional contributor to returns alongside short-term interest rates. The amount of return generated by the spread between long and short positions is ultimately determined by the skill of the portfolio manager. “The net exposure is close to market neutral, targeting a range of between minus to plus ten percent, no more and no less,” explains Nilsson. “The fund’s returns, therefore, do not come from the beta. The returns are created by the stock picking.”

“The net exposure is close to market neutral, targeting a range of between minus to plus ten percent, no more and no less. The fund’s returns, therefore, do not come from the beta. The returns are created by the stock picking.”

Established in 2002 by PO Nilsson and Torgny Prior, PriorNilsson Fonder has transformed from a two-person asset management firm into a specialized stock-picking boutique with an expanded team and a wider range of funds. Despite this evolution, the underlying philosophy has remained unchanged. “Fundamentals are the foundation of our approach. They have always been our guiding principle. We don’t do anything without a grasp of the fundamentals and don’t invest in companies without the fundamentals in place,” explains Nilsson. “Our investment philosophy at PriorNilsson revolves around not necessarily picking the winners, but rather avoiding the losers,” he emphasizes. “This sometimes makes us appear a little bit dull. Maybe we don’t follow the trends in certain stocks where fundamental analysis proves challenging for us. But our approach has paid off over time.”

While different portfolio managers oversee PriorNilsson Fonder’s equity funds, the team maintains a constant flow of idea-sharing and communication. “We have collaborated closely from the very beginning since we started our company,” recalls Nilsson. “We always discuss and exchange different ideas.” Even though decisions may vary across PriorNilsson’s respective funds, dialogue is continuous among all team members. “We talk about everything all the time, every day, all of us. Ultimately, it’s up to each manager to decide whether to act on a particular idea,” he emphasizes. “Discussions are essential because sometimes enthusiasm for an idea can lead to overlooking potential challenges.” By fostering open dialogue, the team can collectively address any concerns that may arise. Communication serves as a vital reality check for each idea proposed.

“Our investment philosophy at PriorNilsson revolves around not necessarily picking the winners, but rather avoiding the losers.”

Operating in a significantly improved environment, PriorNilsson Yield continues its journey of over two decades to outperform the risk-free rate by a few percentage points while maintaining minimal risk and volatility. With enhanced liquidity enabling short positions in smaller-cap stocks, coupled with the resurgence of healthy market volatility and the normalization of interest rates, PriorNilsson Yield finds itself in a favorable environment. “It’s hard to imagine a much better environment than what we are experiencing right now. Both the stock market and credit markets are back to normal, functioning well both fundamentally and in terms of liquidity,” remarks Nilsson. “Now, it’s up to us to do the necessary work and deliver on our objectives.”

This article is part of HedgeNordic’s Nordic Hedge Fund Industry Report.