A Long/Short Bridge Between Stocks and Bonds

 

September 9, 2017 [Alternative Funds, Volatility, market cycles, core asset classes]
Stephen Jimenez


Frothy stocks and well bid bonds can undercut portfolio performance if rates move higher, though long/short equity strategies can support long-run returns.

 

Can long/short alternative equity strategies work as a “bridge” between equity and fixed income? It’s an interesting question recently posed to us by a wealth advisory team. Both asset classes become vulnerable to higher interest rates when valuations are rich.

Historically, the answer is yes: long/short equity strategies have helped protect portfolios, particularly when the stock market became volatile or downward trending.

To be sure, that hasn’t been the case lately. Compared to “core” asset classes, hedge fund returns disappointed over the last three turbulent calendar years. The HFRI Equity Hedge Index returns ranged from a negative 1.0% to a positive 5.5% during the period. That contrasts sharply with the S&P 500 Index’s double-digit gains in 2014 and 2016, bookmarking a near flat 2015, amid high dispersion in U.S. fixed income returns.

But when viewed over a longer time horizon, the picture changes dramatically. Long/short equity strategies have outperformed, and with lower volatility. In the two-plus decades to 2016, the HFRI Equity Hedge Index beat the S&P 500 Index, and did so with 40% less volatility, as seen in the chart below. It also trounced the Bloomberg Barclays U.S. Universal Aggregate Index (U.S. Universal Index).

 

Outperformance Over Market Cycles

Source: Goldman Sachs, Morningstar.

 

The chart shows that long/short equity strategies have worked best over full market cycles. But one of their most valuable features is the potential to offer differentiated returns from those of core asset classes during market swoons. And in the case of liquid alternative long/short equity funds—which allow redemption of mutual fund shares on a daily basis, unlike their private hedge fund cousins—cashing in on returns in up or down markets is easy and efficient.

Ideally, though, investment portfolios should preserve capital during downturns, and grow it via compounding into the future. In the short-run, the performance of any asset class may contribute to—or detract from—overall portfolio returns. As they are designed to mitigate the effects of severe drawdowns, long/short equity funds can, like bonds, increase portfolio diversification, lower correlation and so reduce overall portfolio risk. This is perhaps their biggest advantage for investors in both the short and long terms.

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