Long/short equity strategies can fulfill a number of roles in portfolios: They can be portfolio diversifiers, part of a core equity allocation, or used as a potential buffer to stock-market downturns. In a recent white paper titled An Alternative Viewpoint: A Case for Long/Short Investment Strategies, Lazard Asset Management looks at the strengths and weaknesses of long/short equity strategies and explains how they can be used to manage risk and potentially outperform over a full market cycle.
Lazard also makes the case for its own long/short approach, the Lazard Fundamental Long/Short Equity Fund (LLSOX), which has historically delivered strong risk-adjusted returns and downside protection. Through October 31, the fund had a one-year return of +8.99%, ranking in the top 6% of long/short equity funds, according to Morningstar.
Long/Short Equity Basics
Lazard’s white paper begins by explaining the basics of long/short equity strategies, which combine long and short holdings in an attempt to outperform the broad equity market over a full cycle. Long/short equity managers have more opportunities for “alpha,” since they can express disfavor toward a stock by short-selling it, rather than merely by not holding it. This has allowed long/short equity funds – as represented by the HFRI Equity Hedge Index – to post lighter losses (or even gains) during five of the most recent major stock-market drawdowns.
Net and Gross Exposures
When considering a long/short equity fund, it’s important to understand the fund’s net and gross exposures. For example, a fund that was 60% long and 40% short would have 20% net exposure (60% – 40%) and 100% gross exposure (60% + 40%). A fund that was 100% long and 80% short would also have 20% net exposure – but its gross exposure would be 180%.
Why is this important?
- The greater the net exposure, the more net upside participation for the fund.
- The greater the gross exposure, the greater the total risk.
Just imagine if two funds – each with 20% net exposure but with 100% and 180% gross exposure, respectively – both had all of their trades go the wrong way – i.e., the long stocks went down and the short stocks went up. The fund with the greater gross exposure would suffer greater losses than its counterpart with equal net exposure, but less gross exposure. Gross exposure above 100% indicates use of leverage.
The above illustrates the importance of performing due diligence when considering long/short equity funds. Since long/short gives managers greater opportunities to generate alpha, there is greater dispersion among managers.
In Lazard’s view, investors should have a thorough understanding of the role they want the long/short manager to play in their portfolio:
- As a diversifier,
- For downside protection, or
- Just for market exposure.
Investors should carefully examine the manager’s objectives and his or her philosophy and performance, paying particular attention to volatility, beta, and correlation. Afterwards, the strategy needs to be closely monitored to ensure it remains consistent with its stated objectives.
Lazard Fundamental Long/Short Equity
Finally, Lazard looks at its own long/short equity product: The Lazard Fundamental Long/Short Equity Fund. It seeks superior risk-adjusted returns through purely bottom-up stock selection.
The strategy takes long positions in companies believed to have strong and/or improving financial productivity (i.e., return on equity, free cash flow, etc.) and short positions in stocks with deteriorating fundamentals, negative catalysts, unattractive valuations, and other negative qualities. The fund practices a disciplined early-loss mitigation strategy that Lazard thinks has been critical to its success – as stated earlier, the fund ranked in the top 6% of its peers for the year ending Halloween 2015.
For more information, download a pdf copy of the white paper.
Past performance does not necessarily predict future results.