After a somewhat rocky first quarter in equity markets, we noticed an uptick of advisors and firms searching for long/short equity strategies. As we’ve been involved in these discussions, we looked at some of the top performers in the category over the 3-year time frame and were surprised to see that some had outperformed the S&P 500 Index and/or MSCI World Index. This piqued our interest, so we decided to dig in.
Turns out, the reason they have done so well is because they are not just long, but reeeallly long. The average gross long exposure among these strategies is 150%. They are also short on average about 70%, meaning their net market exposure is about 80%. So, of course these funds have outperformed a category where the beta among the group is 0.5.
There is nothing wrong with this exposure other than the fact that investors should be aware of this additional leverage—the gross exposure of this group is close to 230%. That kind of leverage is fine when things are going your way and you are making all the right calls. In fact, you’ve probably noticed a flood of wholesalers lighting up your phones and populating your inbox with fancy charts about how great their three- and five-year performance is. But remember, this kind of exposure can quickly work against you too if they are wrong.
Case in point: every one of these funds, other than two*, had drawdowns greater than the category over the last three years. Additionally, the down capture of these same funds has been greater than the category, as a whole, by a pretty healthy percentage.
*Note: For the remainder of this post, the two outlier funds mentioned above, have been removed from this analysis. This is because one fund is closed, and the other does not have excess long exposure.
Also, important is that most of these funds were incepted after the last real difficult market environment (2011) when the category was down over 4%, as were global equities. The most recent sustained test we have is 2015 when the average annual performance of these funds was down 1%, while the S&P 500 Index was up and the MSCI World Index was down slightly.
To further illustrate the increased risk or sensitivity to the overall market that these strategies have is their beta to the S&P 500 Index averages 0.81. Should we see a correction at all, these strategies are going to get more of the downside than the category, which as I mentioned above, has a beta of only 0.5. Their performance has the potential to be even worse than that given the leverage on the long side and is dependent on how their short portfolio performs (i.e., not all stocks go down in a down market).
It’s not shocking to me that these funds have done so well lately; it will, however, shock me if they provide the protection they’ve promised when markets become more difficult to navigate.
We’ve seen this happen over and over in the alternatives world, particularly in long/short equity. We have a forward-looking concern that most of the funds that are screening well today for the reasons cited above will fail to meet investor expectations during more challenging environments for the same reasons (i.e., more exposure to the market either implicitly or explicitly than anticipated with outperformance heavily depending on security selection on the long side.) Our fear is that this frustrating cycle may even lead to a declaration at the end to cast aside the entire asset class because they “don’t work” when the reality is they owned a fund that offered a lot of promises, but at the end of the day just provided market risk.
It doesn’t have to be this way!
Part of our job at 361 Capital is to help advisors navigate the universe of these strategies and educate them so that they completely understand the risk-reward potential of their investments. If you know the risks of excessive leverage and still feel comfortable investing in it – then do it, after all your clients rely on your expertise. But, I would caution you that if you are looking for a long/short equity strategy and are screening on three-, or even five-year performance, remember that we have not had a real down market in equities in seven years and many of these strategies that look great now have not been tested.
So blog readers, all I am suggesting today is to keep your skeptical hats on when searching in the long/short equity space. Make sure that you know exactly the exposures you are gaining and make sure you are getting value for the fee you are paying (read more in this blog post). There is wide dispersion in this category, so a wrong selection can be much more painful than in other asset classes.
Lastly, the risk most important to individuals isn’t standard deviation or volatility, it is the risk of losing the money they’ve worked their entire lives for. It is okay if your long/short equity fund underperforms in years the market is crushing it (like 2013 or 2017). The purpose of a long/short equity fund—at least in our opinion—is to outperform in difficult/volatile markets and to ultimately preserve investor capital. Don’t get lulled into funds with great short-term performance only to end up with an over-levered strategy that does not cushion on the downside as much as you thought when markets turn south.
If you have questions about this category or other alternatives, don’t hesitate to reach out to your partner at 361 Capital. Given our extensive alternatives expertise, we are happy to share our insights with you.