In times of market uncertainty and dwindling returns from traditional asset classes, investors are looking to long/short equity strategies for enhanced return and risk protection. In fact, long/short equity, with over $50 billion in AUM, as of the end of August, is by far the largest of the single strategy alternative mutual fund categories tracked by Morningstar.
The potential benefits of long/short strategies are many, especially during times of low expected returns for both fixed income and equities. When markets are delivering strong returns, as was the case in 2013 when the S&P 500 was up 32%, 100 to 300 bps of alpha was nice, but not hugely impactful. If, on the other hand, a long/short manager were able to add that level of alpha on top of 5-7% market returns, it would be a game changer.
Investors find long/short strategies appealing for several additional reasons as well:
- Long/short managers may dampen volatility and hedge against the possibility of a large loss. For example, the maximum drawdown for the HFRI Hedged Equity Index was 29.5% during the financial crisis, while the S&P 500 experienced a drawdown of 50.9%.
- The ability to go long or short provides investment flexibility.
When long-only managers identify a security with a lower expected risk-adjusted return profile, they can do one of two things: underweight it relative to the index or avoid it altogether. Long/short managers, however, have greater flexibility to express their views. A security identified as having excellent characteristics is purchased; one with a poor outlook is shorted; and one with a market-like payoff is put aside until its outlook changes. Greater efficiency is achieved because more of the information uncovered during the research process can be acted upon.
- Liquidity is less of a concern compared to other alternative strategies.
As with all investment strategies, the more assets raised, the harder it is to put those assets to work without lowering return potential. Long/short equity is no exception, but global equity markets are deep enough to mitigate liquidity concerns until a fund raises several billion dollars. In addition to equities, long/short managers are also able to use options, total return swaps or single stock futures to implement their views, all of which can help manage liquidity-related issues.
- Advisors should think of long/short equity as a part of their equity allocation.
Long/short equity strategies derive the bulk of their return from equity beta, albeit in a lessened form from long-only constrained portfolios. Investors, then, should think of long/short equity strategies as equity, and not as part of the amorphous “alternatives” bucket.
Finding the Right Manager
Manager selection within the long/short equity category is paramount, especially considering the wide dispersion among different managers in the category. According to Morningstar, over the last 5 years, the average dispersion between top- and bottom-performing long/short equity managers was twice that of U.S. large cap blend managers over the same time period (i.e., 24.6% vs.12.3% annualized respectively).
The first step to evaluating long/short equity funds is identifying the portfolio’s sources of risk. In long/short portfolios, the lion’s share of risk, as well as return, comes from equity market risk. However, investors may also be compensated for other risks or inefficiencies, such as size, value or momentum. Many cheap passive strategies have been introduced to offer these types of exposures, though, and investors shouldn’t pay up for it. They also shouldn’t mistake it for alpha unless the manager has demonstrated consistent skill in varying exposure to these factors. Additionally, there’s manager-specific risk associated with a manager’s ability to properly identify mispriced risk at the factor or security level.
To evaluate exposure to equity risks as well as style factors, investors should perform two types of analysis:
- A returns-based style analysis (RBSA) measures exposure to equity markets as well as style factors and can isolate alpha, if it exists. For long/short equity, the RBSA must be freed from the long-only constraint.
- A holdings-based analysis (HBSA) produces a more granular factor analysis by confirming exposures through fund holdings. An HBSA is a starting point for attribution, which—if done properly—determines whether the manager is adding value through sector bets or stock selection.
A peer analysis also allows investors to judge a manager’s decisions against all the other decisions he or she could have or should have made. However, there’s a wide range of approaches in this category, and a peer group review should not be used as the only analytical tool.
If a manager cannot generate alpha on the long book, investors should look elsewhere. If the short book is intended as a source of alpha, it should be held to the same standard. However, if the short book merely serves as a hedge, the question becomes whether the manager can add value by varying the net exposure over time through the use of hedges. A manager who maintains a relatively static hedge simply to keep equity beta in line with other long/short funds isn’t adding any value, and investors shouldn’t pay for this.
Long/short equity strategies have the potential to provide more attractive risk-adjusted performance compared to long-only fare, especially if expected returns to fixed income and/or equities will be lower in the coming years, which is our view. Investors who take the time to conduct proper due diligence will be better positioned to reap the benefits of these strategies.