After a decade-long bull market run, the sudden market uncertainty brought on by the COVID-19 outbreak, and its potential long-term effects on the market, understandably have caused many to be concerned about the market losses experienced by their portfolios. Our website captured some of these concerns in the search terms used to access the site, including “calculating return needed to recover from a loss,” “investment calculator with loss and rebound,” “market loss time to recovery calculation,” and “why is downside capture important”. Clearly protecting assets during a drawdown is top of mind and is just one of the reasons why investors find hedged equity strategies, like long/short equity, appealing. Below are several more reasons.
Long/short managers can potentially 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 Great Financial Crisis, while the S&P 500 Index 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. During the most recent drawdown*, the HFRI Hedged Equity Index was down 12.19%, while the S&P 500 Index was down 23.11%. Read more in The Importance of Downside Protection >
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 equity 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. Read more in What is a Long/Short Equity Strategy? >
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. Read more in What is a Long/Short Equity Strategy? >
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 relative to long-only constrained portfolios. As a result, we advise our investors to remember that long/short equity strategies 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, 30 percent bonds and 20 percent “alternatives”. If that investor then fills the alternatives allocation with long/short equity managers (versus true diversifiers), the unintended result will be a portfolio with far more equity than originally desired. The risk/return profile of such a portfolio will be entirely different from one where the alternatives bucket delivers truly uncorrelated return streams, as would be the case with managed futures or convertible arbitrage funds, for example. Read more in The New Core Allocation: Long/Short Equity >
With market volatility likely to last as many uncertainties remain, now may be a good time to reduce risk with long/short equity. If you need help evaluating hedged equity strategies, 361 Capital can offer assistance. As a leader in the alternatives space for nearly two decades, we have extensive experience evaluating these strategies, so please reach out if you have any questions.
Read our recent blog post, Podcast Recommendation: Risk in the Markets >