The Continued Misunderstanding of Long/Short Equity

The fourth quarter rally that put a capper on a fine year for U.S. equities had hardly ended when stories bemoaning the performance of long/short equity began popping up. The S&P returned almost 12% and yet funds, both ‘hedge’ and ‘mutual’, that typically carry net exposures well below 100%, inexplicably underperformed yet again. How could that be? [insert sarcastic looking emoji here]

We know that investors think in relative terms when markets go up, and in absolute terms when markets fall, but as the crew at ESPN would say, “C’mon Man”. How can a category of funds, with say 50%-60% net exposure on average, keep up with, let alone outperform, a long-only benchmark that is up double digits? If investors want full equity exposure, with all the risks that entails, they can easily do so. But when investing in long/short equity, they knowingly choose, for various reasons, to go with a more tightly risk-managed approach to equities. The idea of course, is to produce strong risk-adjusted returns over time, where “risk-adjusted” has to be specific to the strategy under review, given the category’s heterogeneity.

Is your manager investing in value stocks? Momentum stocks? Quality stocks? Low volatility stocks? Small cap stocks? International stocks? 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 how well a manager performed has to be measured against the risks prevalent within a particular portfolio.

But long/short is evidently a mystery to even some tasked with analyzing such funds professionally. Take the following quote from someone who will remain nameless because we’re good guys, but who is evidently, based on his title, in the role of vetting mutual funds.

“The only thing you can be really sure of is that performance will be different from its benchmark…They [long/short funds] are far from benchmark huggers. Perhaps the most applicable benchmark would be cash.”

To which we say, no, no, no. It’s as equally incorrect to measure stock portfolios with decidedly positive net exposures against cash, as it is to run a straight up comparison to long-only equity benchmarks. Know your manager’s story, and verify it with the help of multi-factor regression, holdings-based analysis and attribution analysis. Only by doing the work to understand a manager’s portfolio can you determine whether you should be disappointed, or elated, despite whatever the S&P happened to return.