Hedge funds encompass a wide range of investment techniques across multiple asset classes. As such, returns are often determined more by the specific trading strategy a particular fund employs, than by the particular asset class in which it deals. Related to this concept of asset class versus trading strategy is the idea of risk premium, as investors accept equity and bond market risk with the expectation they will be compensated for taking that risk. Hedge funds also have expected risk premiums, but compensation is based on the investment strategy rather than the asset class. The expected return for these risks may vary over time, creating tactical opportunities at a sub-asset class level. Here we focus on long/short equity strategies
Residents of the United States, please read this important information before proceeding
What is long/short equity?
Long/short equity managers typically build a portfolio of long positions of stocks the manager believes to be undervalued and short positions the manager believes to be overvalued. Being short means the manager has “sold” the shares with the intent of buying them back at a lower price in the future. This is done by borrowing the shares from a broker for a fee and then buying the shares later to “repay” the borrowing. This repayment is known as “covering” a short position.
The process of being both long and short allows managers to focus on the risks they want to take, while removing risks that the manager does not feel they want to take. As a stylised example:
Average correlation between 45 equity country benchmarks reached all time highs in 2012
Consider a world where Coke and Pepsi only make their eponymous colas. A manager may have a view that Pepsi has better future prospects and the shares are more attractively priced compared to Coke. The manager would buy shares in Pepsi and go short shares in Coke. Why?
Well, the manager’s risk is restricted to the insight of the relative returns of Pepsi vs. Coke shares. The manager is not taking a view on the market for carbonated cola drinks and the risks therein; e.g. regulation of sweetened beverages or changing consumer taste. Nor is the manager taking a view on the direction of the equity market overall, as gains and losses due to changes in valuations of stocks in general will offset this. By being long and short, the manager has isolated the factor on which he has insight and hedged away the risks on topics where he has no special view.
This can be applied not only between two single stocks, but across entire sectors or even whole markets. Long/short equity managers are certainly taking risks but they are specific risks and not systematic market risks that may be present in a conventional or long-only portfolio. This hedging of market risk is what makes long/short equity and alternative trading strategies (ATS) in general, so attractive in portfolios. These strategies lack the market risks that investors often already have in long-term equity or bond portfolios and therefore have a low correlation to the returns from these other investments, therefore creating diversification. Wise investors know that it is not simply holding a large number of investments that makes a portfolio diversified; it is holding several different kinds of investments (i.e. don’t put all your eggs in the same kind of basket). We can measure how different each investment is to all others based on its correlation, a measure against which
ATS strategies truly excel. The table below shows the historical correlations between developed market equities, developed government bonds and several different hedge fund sub-strategies, including long/short equity. The two “flavours” of long/short equity of interest are the Equity Hedge Index and Equity Market Neutral Index. Correlation factors of 1.00 show perfect correlation; i.e. they move in perfect tandem and provide no diversification benefit. Ideally, we look for correlations close to zero as it implies the return profiles are independent of each other and therefore provide a diversification benefit. Since
we tactically favour equity markets, we are willing to accept some correlation (it is a good thing if they are both moving together in an upward direction), but we do not want correlation to government bonds if we think there may be an increase in interest rates in the medium term.
For each sub-strategy within ATS, we consider the market conditions that will be most amenable to that strategy. There are times when markets have a strong element of momentum and certain systematic strategies will thrive. At other times, macro-economic forces will dominate the sentiment of investors, and so called macro funds can flourish. In current market conditions, we believe that corporate earnings growth (or lack thereof) will be the predominant driver of equity market returns. In such an environment, managers that have a strong process designed to evaluate the fundamental, bottom-up performance of companies will have an edge. In short, we think we may be entering a stock-picker’s market and that is exactly what fundamental Long/Short Equity managers do.
Factors shaping our tactical view
Whilst long/short equity managers account for around 40% of the hedge fund universe and should feature significantly in a diversified ATS portfolio, we believe the environment is particularly fertile for this strategy. In our discretionary funds we opted to overweight long/short equity in January 2012 and retain our positive stance for the following reasons:
Intra-stock and intra-sector correlation
A broad measure of dispersion has declined over the past two years creating an opportune environment for idiosyncratic stock-picking, as increased dispersion of returns creates more opportunity for long/short managers. In some respects though high dispersion is a risk factor for long-only investments. Imagine if half the stocks in the market went up and half went down, then overall market returns would be zero. However, that risk factor in a long-only context becomes the opportunity set for long/short managers.
Increased focus on companies vs. politics and policies
In calm macro-economic environments, stock prices respond most sensitively to earnings and fundamentals, acting independently from macro-economic variables. Since the financial crisis in 2008 macro forces and government policies have oftentimes overwhelmed stock specific factors, creating challenges for idiosyncratic stock-pickers. As these forces abate, we expect rigorous fundamental analysis to be rewarded.
As business models are disrupted, clear winners and losers will emerge
Fewer “short squeezes”
In 2013 high short-interest stocks (stocks that have many short sales against the shares) outperformed the S&P 500 Index by a large margin. In extreme cases, there were so called “short squeezes” or “covering rallies” whereby short sellers, facing rising prices all rushed to cover their shorts at the same time. This can lead to a spike in the stock price and big losses for short sellers. Given the pain endured, many hedge funds lost capital and switched to run long-only or long-biased portfolios. However, over a longer time span these short-interest stocks have underperformed the index by an average of 7%. If we are now seeing evidence of conditions normalising, short-covering rallies should ease in the future, and the longer-term underperformance may re-emerge.
Cloud computing, e-commerce, mobile connectivity, peer-to-peer networking and artificial intelligence are disrupting existing business models, leading to a powerful creative-destructive wave and an abundance of long and short opportunities.
Challenges in emerging markets
The slow-down in emerging markets and funding pressures within the Chinese financial system are affecting global risk appetite. China’s transition away from fixed asset investment towards consumption and services, allied with the challenges posed to emerging economies tackling current account deficits, carries broad implications across sectors and companies globally. Managers are positioned to profit from these economic adjustments. For instance, a particularly vulnerable sub-sector is mining equipment producers, which have enjoyed supernormal profits for many years and responded by expanding capacity. If Chinese infrastructure growth slows, equipment suppliers with limited pricing power may suffer acute margin pressure.
Aftermath of quantitative easing
The unwinding of quantitative easing (QE) is taking place gradually, and the Fed is clearly still concerned to minimise what it sees as economic tail risk. Volatility is likely to rise as monetary normalisation occurs, but it will be doing so from very low levels: QE and the Fed’s concerns have been equivalent to an increase in the supply of portfolio insurance, and its price – implied volatility – has fallen. This low volatility enables long/short managers to hedge against tail risks using inexpensive put options.
The case for long/short equity
Though growth is likely to be more synchronised in 2014 than it has been in recent years, some divergence – relative economic risk – remains. The US and UK seem to be gaining momentum in their economic recoveries, while Japan has deployed industrial strength policy tools to defibrillate their moribund domestic economy: the medium-term prognosis of the world’s third largest economy is still unclear. Europe is no longer in headline crisis mode, but underlying growth remains subdued. And, finally, the emerging market economies should no longer be thought of as a homogeneous block, since economic performance, as well as equity market returns, are likely to be extremely varied between regions and countries. All of these forces will create winners and losers among companies, different risk appetites between capital allocators from different markets and a potentially broad range of outcomes for investors with concentrated equity portfolios. These factors can lead to high dispersion of stock price returns, a key raw material for successful long/short equity managers.
Investors should remember that long/short equity is not a wager on a region or sector. An Asian Long/Short fund does not necessarily provide exposure to rising Asian stock prices, in fact, precisely because managers can be short, investors may actually have nominally negative exposure to a particular region. The regional descriptors of long/short equity funds merely indicate the stock markets from which that manager will select investments.
Overall, we remain positive on developed market equities, but there is a real possibility that the road to returns will be bumpier in 2014 than in 2013. In this type of market environment, having the smoothing effect of offsetting short positions can significantly reduce the volatility of investors’ portfolios. Long/short equity provides the potential for real growth from strong companies, with less of the ebb and flow that comes from changes in market sentiment.
With divergent prospects across developing and emerging market economies, as well as individual companies and sectors, we believe the opportunity set for fundamental-driven long/short equity investing is compelling. We advocate allocating to resourceful and experienced investment teams with a sustainable, repeatable process.