Long-Short Equity Solves Dual Problem for Investors

Portfolio strategist Paul Cook says that real returns on fixed-income investments are likely to be very low, or even negative, going forward; and that this prospect has ushered so much money out of bonds and into stocks that investors now face a “risk/return dilemma.” In his paper The Dual Advantage of Long/Short Equity, published by Boston Company Asset Management, Mr. Cook says that the shift from bonds to stocks has made investors’ portfolios more volatile, and that stock-market investors are “assuming a greater risk of significant loss” if the stock market experiences a substantial correction.

Fortunately, Cook and the Boston Company offer a solution to this dilemma: Long/short equity, which the paper says “repackages the raw material of public equity markets in a way that lowers risk.” This notion is highlighted in the below chart:

Boston Company Risk Return Plot Long Short Equity

By removing the long-only constraint, long-short equity managers can short-sell stocks they believe will perform poorly, in addition to buying stocks they think will perform well. During bear markets, it’s easier for portfolio managers to generate returns if they’re allowed to short; and additionally, the combination of long and short in a portfolio reduces market exposure (beta) while highlighting the manager’s stock-picking ability (alpha).

Traditional Asset Problems

Cook explores the problems with traditional assets in two separate sections in the paper, The Bond Problem and The Equity Volatility Problem.

Cook argues that bond yields, which are lower than they’ve been for decades, must “normalize” in the near future, and that will make prospective real returns either very low or even negative. Bonds have been used as a diversifier for otherwise all-equity portfolios, but with the asset class appearing to be a likely loser over the next several years, investors can no longer rely on bonds to provide this role for their portfolios.

The Bond Problem may be a new one for fixed-income investors, but the Equity Volatility Problem is one familiar to stock investors – it’s just likely to be even worse with the flood of bond-investor money into the equity markets. Cook points out that equity volatility has ranged from 15% for big-cap U.S. stocks (as measured by the S&P 500) to almost 24% for international equities (as measured by the MSCI Emerging Markets Index), with markets experiencing maximum drawdowns of more than 50% over the past two decades. If the future is even more volatile, then investors would be well-advised to diversify their holdings to avoid similar drawdowns.

Long/Short Equity Advantages

Cook says the return of long/short equity strategies have been “comparable or even better” than long-only strategies over the past 20 years, during which time the total return of the Dow Jones/Credit Suisse Long/Short Equity Hedge Fund Index was 9.93%; while the risk, as measured by the standard deviation of monthly returns, was 9.58%. The S&P 500’s return over that same time was a bit lower at 9.53%, while risk was much higher at 15.2%. Cook suggests that the disparity between the risk/return propositions of long/short equity and long-only equity will be even greater, going forward.

“The combination of equity-like returns and lower volatility makes long/short equity an attractive addition to balanced bond and equity portfolios,” according to Mr. Cook.  “Long/short solutions help solve for the dual problems of low fixed-income returns and high equity-market volatility, making this seem like an optimal time for this liquid alternative strategy.”

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