Is Your Long/Short Manager Over Exposed?

I’m going to start with the assumption that if the title of this blog caught your eye, you probably already allocate to one or more long/short equity managers. And with that, I’m going to skip over the general arguments for long/short equity strategies, except to say that if you do use long/short equity, it is likely in part due to where we sit in the market cycle in terms of valuations (high), interest rates (low and rising), margin levels (high and likely to be falling), and Fed policy (it’s becoming less accommodative).

If that inference is accurate, and you aren’t already keenly aware of just how much market exposure your manager is taking to generate returns, it’s time to take a close look, lest you be caught flat footed in the next correction or crash.

While most long-only managers remain fully invested, save for frictional cash, long/short equity managers vary greatly in terms of both their net exposures and their betas (which can be substantially dissimilar from what the net exposure may imply, because of differing beta profiles for the long and short books). Further, many long/short equity managers vary their net exposures over time. In some cases, quite substantially so.

Done well, that can certainly be a meaningful source of alpha. But let’s be honest, it’s a form of market timing—or at least introduces the same risk—even if it’s a result of the ever-changing opportunity sets for the long and short books. Generating alpha on the long book is hard. Generating alpha on the short book is harder. And generating alpha with any consistency by varying net exposure might be the most difficult thing a manager can do.

We were curious how many managers vary their net exposure in a material way over time, and how funds tend to be positioned at this stage of the cycle. We explore this topic further in a recent article I wrote for Investment Advisor magazine.

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