The market fireworks that started in February have continued well into June with the S&P 500 rising or falling greater than 1% for 39 days so far in 2018 (through June 30). And that’s more than double the number of days that experienced this movement in all of 2017.
The return of volatility has reminded us all that protecting on the downside is as important as capturing growth on the upside. Long/short equity has the ability to do both. However, conducting due diligence on long/short equity managers is more complex than their long-only counterparts. We’ve provided four starting points for you to consider in the fund selection process.
- Size is the enemy of a long/short equity strategy. As with any active investment strategy, when too many assets are raised, it is harder to put those assets to work without lowering the strategy’s return potential.
- How does the manager use the short portfolio? Some strategies intend to use the short side of the long/short equity portfolio as a source of alpha. If so, the manager should demonstrate a history of adding value through shorting stocks. Other managers use the short portfolio as an equity market hedge. If this is the case, the manager should be adding value by varying the net exposure to equities over time through hedges.
- What is the investment team’s process for shorting stocks? The ability to short stocks more fully utilizes a manager’s stock research or screening process. However, shorting stocks is new for some managers. Fiduciaries should consider the investment team’s experience in shorting stocks and ensure there is a systematic process for identifying stocks to short.
- The long portfolio matters too. Understanding the short portfolio is important, but the due diligence process should also include a review of the manager’s ability to add value through stock selection in the long-only portfolio.
With the market fireworks likely to continue into the second half of 2018, the need for long/short equity strategies may be greater today than it’s been in decades.
Read our last blog, You’re Paying What? Breaking Down Long/Short Fees >