Putting the Short Back in Long/Short Strategies


June 28, 2019 [long/short strategies, hedging, downside capture ratio, balanced portfolio]
Josh Yafa



A long/short equity strategy can help mitigate volatility and provide a differentiated return stream. But, there are issues to consider.

Many long/short equity funds are drifting towards the long side of their long/short mandates, and some investors in these funds may be disappointed when equity markets drop.

Disappointment could be fairly widespread. Long/short equity liquid alternative funds, valued for their ability to cushion portfolios from downside risk, have continued to grow in popularity. According to Morningstar, assets in long/short equity strategies have grown from just under $400 million in 2000 to $28 billion in 2018.

Protection on the downside

Conceived in the late 1940s, the first “hedged” fund was considered a conservative investment strategy, using short selling of individual securities to avoid market risk. Selling a security short is a bet that the security will decrease in value. The short seller borrows shares of the security, and then sells the shares at current market price. As the security’s price falls, the shares are repurchased by the short seller and returned to the lender, with the short seller pocketing the difference.

As designed, these fundamental long/short strategies have helped mitigate risk. Over the last 20 years, Morningstar’s Long/Short Equity category experienced just over a third of the volatility of the S&P 500 Index. Perhaps more importantly, over that period, these funds experienced just under 30% of the S&P 500’s losses when the index fell, as measured by the Morningstar category’s downside capture ratio.

Why a fundamental, bottom up approach has an edge over quant

However, many long/short funds have strayed from the original fundamental long/short mandate. Lured by the robust equity returns of the last decade, the typical long/short fund today is roughly 60% net long. With little focus on maintaining a balanced short portfolio, when a bear market does arrive, some of these funds may suffer the painful losses of their long-only brethren.

Making matters more challenging are the rise of long/short funds that rely on quantitative algorithms to screen for a variety of general metrics, such as price-to-earnings or price-to-book ratios. By relying on these metrics, “quant” funds are often not able to apply the nuanced, stock-by-stock analysis required to accurately assess a company’s true intrinsic value. This is particularly true when evaluating stocks whose valuations could be a reflection of more complex attributes, such as a competitive moat or intellectual assets. Often, these stark differences are not revealed until the volatile reversal of a factor-led market.

Single name shorts to cushion on the downside

To assess nuanced stock valuations and help achieve the outcomes that long/short equity funds were designed to provide, investors should consider a long/short strategy that employs in-depth, fundamental research on a stock-by-stock basis rather than a quant fund that sweeps in a swath of stocks based on an algorithm. Beyond stock-by-stock research, funds must also adhere to a disciplined process of maintaining a balanced exposure of individual long and short positions in order to provide a differentiated return stream and to mitigate portfolio volatility when markets fluctuate, regardless of direction.

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