2020 has been interesting for about a million reasons, all of which we won’t get into here. But one thing it has highlighted in our little corner of the investment universe is the massive dispersion that exists in the long/short equity category.
The category is incredibly diverse. It includes strategies focused on individual sectors and regions, ranges from very conservative strategies with little to no net market exposure and strategies that employ a great deal of leverage; it includes fundamental and quantitative approaches, as well as funds that aren’t even really long/short. We’ve written about this before given the challenges this variety creates for investors. Regardless of this dispersion, what investors typically express they want in a long/short fund is a strategy that provides equity-like exposure with lower risk, and one that participates on the upside, but more importantly protects on the downside.
2020 is the type of year individuals will look back on to make a determination about a fund’s ability to provide just that. But they will have to do a lot of work to put what has happened so far in the proper context. To help with that, for the next two blogs, we thought we would give an overview of what has happened in the category so far this year, aiming to explain some of the reasons for this dispersion, as well as highlighting a few remarkable outliers. Next week, we will dive a bit deeper into the performance of these outliers and provide investors with some considerations when evaluating them and other strategies in the space.
“Want to forget” 2020 crowd
Through 9/30/2020, the S&P 500 Index is up just over 5% and the category overall is essentially flat. Unfortunately, the bottom quintile of funds is down 15% on average, ranging from down over 10% to over 21%. How is it possible that strategies meant to outperform in down years and limit volatility are down so much more than the market?
The largest culprit to underperformance appears to be manager exposure to value. As you can see in the chart below, regardless of market cap, growth has outperformed value in 2020 by a very significant margin.
Source: JP Morgan
Strategies with a value bias would have a hard time overcoming this headwind no matter what else they did in their portfolios. Sure enough, over half of the funds in the bottom quintile have a value bent, whether they are fundamental managers or quantitative/factor-based funds. Not all factor funds underperformed. Those that had more flexibility around factor exposures, or who had less leverage did much better. But funds with any kind of value bias have had a tough year.
While value exposure has had the largest impact by far, other funds that have underperformed are various tactical, rules-based strategies, as well as a couple opportunistic managers that were not able to time markets or had over/underweights that did not play out how they may have expected. While this performance is certainly frustrating to investors and managers, it is not entirely unexpected. Value exposure has been a significant drag and unfortunately opportunistic managers and rules-based strategies do not always get every market call right.
2020 and the “banner-year” crowd
On the completely opposite side of the coin, the top quintile of funds has performed incredibly well. On average it is up 18.1%, with the range of strategies up between almost 9% and over 46%. The common thread among many of these funds is an exposure to growth (specifically tech stocks) and momentum. Momentum stocks are up over 18% so far this year, so it makes sense why strategies with a bias towards those names are leading the way.
The other feature of many of these top performers is their opportunistic approach. Opportunistic strategies aim to add value from long and short stock selection, as well as total market exposure, and at times, tactical sector/country positioning. Many of these funds did well because— as opposed to some bottom performers with a similar approach —these managers got their calls right. This top-performing group also includes: a sector fund, a few not-so-pure long/short funds (e.g., event driven, volatility), and trend-following or tactical, rules-based funds.
Overall, this outperformer group is comprised mostly of managers who got their calls right and/or who had heavy growth exposure. What is interesting, however, is that rules-based managers and opportunistic managers appear in both the top and bottom quintiles highlighting the difficulty of manager selection in this category.
While the top quintile of managers is up on average 18%, a significant amount of that number is due to three funds that are each up over 30%; they account for almost a quarter of that YTD average. That is a shocking return, and in such an up and down year it begs the question, why is their performance such an outlier?
Two of the funds are opportunistic and they appeared to have timed the market almost exactly right, i.e., they got out of the market in February/early March, and then back in late March/early April. In addition to getting the timing part right, they both have a growth mandate which no doubt helped in a year with such significant spread between the performance of growth and value names.
The third outlier is quite a bit different and not a ‘traditional’ long/short fund. It is a strategy that is tactically exposed to equities paired with certain volatility trades. There’s nothing wrong with that at all, it is just a different approach. Either way, unlike some of the underperforming funds, these funds all appeared to be in the right place at the right time.
We have seen this kind of significant short-term outperformance before, and it is often the root of investor’s frustration with the category overall. How do you know if you got the “right” one? How do you find one that can deliver this type of performance and invest in it before anything happens? What evidence is there for you to determine that this performance (good or bad) will be repeated in the future?
In next week’s post, we will examine these outliers a bit deeper and help address these observations and questions. In the meantime, don’t hesitate to reach out to us if you have questions on the category this year or overall, we are happy to share our insights.
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