Through December 7th, the global equity markets have advanced by 20% year-to-date, as measured by the MSCI World Index, and they’ve annualized at close to 14% since the end of the Great Financial Crisis. Taking risk in all of its forms has been amply rewarded, and it’s been easy to ignore strategies that can protect on the downside, like Long/Short Equity. But looking at individual fund results for the category, we find that many long/short equity funds have performed quite well this year, with the top performers coming close to, and in some cases exceeding, the performance of long-only equity strategies. Of course, the opposite is true as well, with bottom performers not only failing to keep up, but actually turning in negative returns. We suspect that is a result of trying to time the market and swinging to a net short position.
In any event, the truth is that the long/short equity category is far from homogenous. The category contains large cap U.S. focused funds, global funds, and emerging market funds, to name a few. The strategy and related beta exposure differences are evident when looking at the spread between the 25th percentile and the 75th percentile for long/short equity funds, compared to the same spread for traditional categories, like large core. Year-to-date, that spread for large core has been about 300 basis points, while the spread for long/short equity has been close to 930 basis points.
The meaningful differences that exist across the category are important to pay attention to as we near year end, and investors start the process of evaluating their funds. Too often, return on its own is the preferred metric to judge the effectiveness of a strategy. So how should investors think about analyzing long/short equity funds?
In order to properly analyze any investment strategy, it’s imperative to identify the risk factors embedded in the portfolio. All returns come from bearing risk in some form, so what risks are prevalent within long/short equity portfolios? At the most basic level of course, investors in long/short equity strategies take on equity risk, and therefore garner the lion’s share of their return from the equity risk premium. As an aside, because most long/short funds are systematically long biased (and few ever get remotely close to being net short), we believe long/short equity should be allocated to as part of the equity allocation, and not the amorphous “alternatives” bucket. Ultimately, long/short equity delivers equity beta, even if in a lessened form than long-only funds.
Returning to the drivers of return in a long/short equity portfolio, in addition to the equity risk premium, investors may be compensated for exposure to other risk premia, such as size, value, or momentum. With the proliferation of cheap passive strategies that provide exposure to these same factors, investors should not pay up for these exposures, and should not mistake them for sources of “alpha”, unless of course the manager can demonstrate skill in varying exposure to these factors in a consistent manner. A potentially effective way to measure exposure to not only the equity market as a whole, but to style factors, is to employ returns based style analysis (“RBSA”), which can isolate alpha, if it exists. Importantly, for long/short equity, the RBSA must be freed from the long-only constraint.
In conjunction with RBSA, and because of the inherent limitations of such analyses, investors should confirm exposures with holdings based analysis (“HBSA”), which additionally allows for even more granular factor analysis. Examining actual positions in turn is a starting point for attribution, which, if done properly, answers the question of whether or not the manager is adding value through either sector bets or stock selection. Importantly, the manager’s ability to add value through stock selection on both the long and short books must be examined. If a manager cannot generate alpha on the long book, there is no question that investors should look elsewhere. But what about the short book? Our answer is that it depends. If the short book is intended to be a source of alpha, then the short book should be held to the same standard. If however, the short book merely serves as a hedge, then the question turns to whether or not the manager can add value by varying the net exposure over time through the use of its 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 be paying for this “service”.
Long/short equity strategies have the potential to provide superior risk-adjusted performance compared to long-only fare, but there is additional complexity to these strategies. While that complexity provides the opportunity, complexity too often obfuscates the manager’s true impact, and investors who shortcut the due diligence process may suffer as a result.