Long/Short Equity is by far the largest of the single strategy alternative mutual fund categories tracked by Morningstar. Why? Investment flexibility and the potential to dampen portfolio volatility are among the top reasons. But not all funds are the same—and finding the right manager is critical.
In times of market uncertainty and dwindling returns from traditional asset classes, investors are looking to long/short equity strategies to capture equity-like returns while managing downside risk. In fact, long/short equity with over $52 billion in assets under management as of November 30, 2015, is 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 percent, 100 to 300 basis points of alpha was nice but not hugely impactful. If on the other hand, a long/short manager can add that level of alpha on top of hypothetically 5-7 percent market returns, it’s a game changer.
Investors find long/short strategies appealing for several additional reasons as well:
Long/short managers can dampen volatility and help mitigate 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%. An investor who experienced the loss of the HFRI index needed to generate a return of approximately 42 percent to get back to even, while an investor in the S&P 500 required more than double—a return of 104 percent. Point being, while a 29.5% loss is undoubtedly tough to stomach, climbing out of that hole is far less daunting than what long-only investors faced.
The ability to go long or short provides the ultimate investment flexibility that is fully responsive to manager conviction. When long-only managers come across 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, on the other hand, have greater flexibility to express their views on all securities that they research. A security identified as having superior characteristics is purchased; a security with a poor outlook
is shorted; and a security believed to have a market-like payoff is put aside until such time that either valuation or fundamentals turn it into a higher conviction long or short position. Greater efficiency is possible 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. It’s no secret that size is the enemy of all investment strategies: the more assets raised, the harder it is to put those assets to work without incrementally lowering the portfolio’s 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. (Depending, of course, on the market cap characteristics of the long and short book.) 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. Investors should additionally keep in mind that our observations have shown that hedged equity managers tend to take a long position on smaller stocks and short larger stocks over time. As such, it’s best to consider the overall liquidity profile of each manager during the underwriting process.
We believe 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. As a result, we advise our investors remember that long/short equity stategies involve equity, which sets these strategies apart from some of the other strategies in the amorphous “alternatives” bucket.
For example, say an investor determines that the optimal asset allocation is 50 percent equities, 35 percent bonds and 15 percent alternatives. If that investor then fills the alternatives allocation with long/short equity managers, the unintended result will be a portfolio with far more equity than desired. The risk/return profile of such a portfolio will be entirely different from one where the alternatives bucket delivers truly uncorrelated return streams, such as through managed futures or convertible arbitrage funds.
Finding the Right Manager
Manager selection in long/short equity is critical—especially considering the wide dispersion among different managers in the category. In order to reap all the potential benefits long/short equities may provide, investors need to perform careful due diligence before selecting the right fund for their needs. To put the importance of manager selection into context, 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%, 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 seek to 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 exposure, though, and in my view, investors shouldn’t pay up 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),which not only measures exposure to equity markets as a whole but to style factors as well, can isolate alpha. Importantly for long/short equity, the RBSA must be freed from the long-only constraint.
A holdings-based analysis (HBSA) allows for an even more granular factor analysis by confirming exposures through fund holdings. An HBSA 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.
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. There’s a wide range of approaches in this category, however, and a peer group review should not be used as the only analytical tool.
It is important to measure the manager’s ability to add value through stock selection on both the long and short books. If a manager cannot generate alpha on the long book, there is no question that an investor should look elsewhere. But what about the short book? It depends. If the short book is intended to be a source of alpha, then it 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.
It’s clear that long/short equity strategies have the potential to provide superior risk-adjusted performance compared to the long-only fare, especially if investors believe that expected returns to fixed income and/or equities will be lower in the coming years, which is our view. It does pay, however, to do some homework first. Investors who take the time to investigate prospective fund managers’ track records will be better positioned to reap maximum benefits.