With uncertainty in the air, the potential for subdued-to-negative economic growth looming, and a bleak outlook for fixed income, advisors are challenged to rethink foundational portfolio elements of investor portfolios—which means seeking out strategies that bolster the core going forward.
In investing, the “core” has traditionally consisted of developed market equities and investment grade debt—commonly referred to as “the 60/40”. Increasingly over the last decade, investors—both retail and institutional—have introduced a growing number of diversifying elements to that core, including commodities, floating rate and high yield debt, emerging market assets, and hedge fund strategies, to name a few. Those asset groups have, in portfolio construction lingo, been termed “satellite” allocations.
But not all satellites are distinctly different from core assets. Of all of the satellite strategies, the one that most closely resembles the foundational components of a typical portfolio is long/short equity. It is after all a strategy, not an asset class, which invests in equities, and more often than not, does so with net exposure well below 100%; and that ends up looking quite similar to a combination of equities and cash or bonds.
As an aside, for those new to long/short equity, you may be wondering at a conceptual level why you should even consider investing in such a strategy. Our response is that portfolio managers and analysts, whether discretionary or quantitative, expend tremendous effort in identifying securities with higher expected risk-adjusted returns than the market at large. Through these efforts, they likewise come across securities with lower expected risk-adjusted return profiles. Long-only managers utilize such information primarily to avoid stocks with poor outlooks. Long/short equity managers, on the other hand, are afforded greater flexibility to fully express their views on all securities that they research, improving investment efficiency. Greater efficiency is achieved because more of the information uncovered during the research process is acted upon. A security identified as having superior characteristics is purchased, a security with a poor outlook is shorted, and a security with 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.
By exploiting a larger opportunity set while reducing market exposure, long/short equity has historically generated compelling risk-adjusted returns. But let’s continue with the idea that long/short equity has characteristics similar to core assets. A correlation analysis of the return stream for equities, as represented by the S&P 500 Index, and long/short equity strategies, as represented by the Credit Suisse Long/Short Equity Index, reveals that from April 1994 through September 2020, equities and long/short equity strategies exhibited a correlation of about 0.60. As alluded to earlier, this fairly high correlation is to be expected given that long/short equity strategies derive the bulk of their return from equity beta, albeit in a lessened form relative to long-only constrained portfolios. Consider the following risk and return characteristics.
|Annualized Return||Standard Deviation||Sharpe Ratio||Maximum Drawdown|
|S&P 500 Index||10.05%||14.87%||0.66||-50.95%|
|Barclays US Aggregate Bond Index||5.50%||3.48%||1.52||-3.83%|
|60% S&P 500 Index / 40% Barclays Aggregate Bond Index||8.61%||9.07%||0.93||-32.54%|
|Credit Suisse Long/Short Equity Index||7.47%||6.71%||1.08||-19.68%|
Source: Morningstar 04/30/94-09/30/20
As you can see above, long/short equity strategies have come close to matching the performance of equities with a much lower level of volatility than the 60/40 stock/bond portfolio, and with substantially smaller drawdowns. (Note that this over a time period when the yield on the 10-Year Treasury went from 7.06% to 0.69%, which was unquestionably beneficial to the performance of investment grade debt.)
Ultimately, we believe long/short equity should replace, at least in part, core assets rather than being lumped in with the amorphous “satellite” bucket because of the dangers inherent in the latter approach. Too often, asset allocation and manager selection are conducted independently, rather than in an integrated and iterative fashion. And if, for example, an investor determines that the optimal asset allocation is 50% equities, 30% bonds and 20% “alternatives”, and then proceeds to fill 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, for example. Manager selection aside, it is our belief that the need for long/short equity strategies may be greater today than it’s been in decades due to the market environment in which we find ourselves; both with continuing equity market uncertainty and historically low interest rates. The benefits to including long/short equity in an otherwise traditionally diversified portfolio are many, including its ability to deliver disproportionate upside and downside capture ratios.
The bottom line is that investors need to improve upon the return potential of an investment grade debt portfolio without taking on too much equity risk, and it’s our belief that adding long/short equity while reducing both long-only equity and investment grade debt does just that.
Learn more about choosing the right long/short equity fund and the importance of upside/downside capture in The New Core Allocation: Long/Short Equity >