February ushered in volatility like we’ve not seen in quite some time. And whether the first several days were merely a blip on an otherwise steady climb, or the signaling of a broad regime change, we don’t yet know. However, we still believe the U.S. stock market is about as broadly overvalued as it has ever been across a variety of valuation metrics. With inflation fears pushing interest rates higher, now would seem to be a highly advantageous time to shift at least a portion of long-only equity exposure to long/short equity strategies.
Doing so would provide much of the upside of the stock market should it continue to reach new heights, but with considerably better downside protection if the market rolls over or experiences more frequent bouts of volatility. Consider that while the S&P 500 Index suffered a 51% drawdown during the Great Financial Crisis, the Credit Suisse Long/Short Equity Index fell by a much more manageable 22%. (We say “manageable” because the returns required to earn back those losses were a daunting 104% for the S&P 500, but only 28% for the Credit Suisse Long/Short Equity Index.)
While long/short equity is appropriate for any type of investor willing and able to take at least some equity risk, it is especially ideal for those who want equity exposure with less volatility and more downside protection. As such, investors who are closing in on the need to draw down their investments, e.g., those nearing college or retirement, should be inclined to adopt the more tightly risk-managed approach to investing in equities that long/short equity strategies offer.
So, how should investors go about picking a long/short equity fund? We believe the following areas deserve scrutiny during the due diligence process:
1. What is the strategy employed and why should it work? In other words, what is the inefficiency that the manager believes exists? Why does it exist? Why should it reasonably persist? And how does the manager intend to exploit this inefficiency?
2. Manager experience. Shorting stocks is not easy and even successful long-only managers often struggle.
3. The net exposure profile. Is it relatively static or actively managed, and if the latter, how and why?
4. Evidence of true alpha generation on both the long and short books. 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”.
Finally, we believe it’s best to observe long/short equity funds, or any fund for that matter, over a full market cycle. Focusing on short periods of time and/or recent performance will most likely lead to sub-optimal manager selection.
Read more in The New Core Allocation: Long/Short Equity >