Long/Short Equity

Introduction

Long-Short Equity-1The long/short equity strategy is one of the more nimble hedge fund strategies whereby managers seek opportunities across global equity markets with the objective of outperforming traditional markets over a given cycle. The concept behind the long/short equity strategy is simple: investment research uncovers expected winners and losers and the hedge fund enhances its potential return capabilities by taking a position in both. Accordingly, one of the major advantages of the long/short equity strategy is that the managers have the flexibility to express their views in opposite directions. The long/short equity fund manager buys long positions in stocks they believe will increase in value (“the long book”) and shorts positions which they feel will decrease or offer a suitable hedge against certain market or sector risk (“the short book”). The combined portfolio creates enhanced opportunities for idiosyncratic (i.e. stock-specific) gains and reduces market risk as the short holdings offset the long market exposure. In all, long/short equity managers largely target equity-like returns without the high volatility typically associated with long-only strategies in order to provide a higher compounded rate of return over time.

Long-Short-Equity-2What are long/short equity funds?

Long/short equity managers are active in equity and equity derivative securities in which they maintain both long and short positions in order to generate returns. The managers aim to deliver returns in excess of the broad equity markets while seeking to assume less risk in the process. Unlike traditional long-only equity managers, those that pursue the long/short equity strategy have the ability to use their “short book” to express a negative view on a stock or as a means to hedge market risk in periods of heightened volatility. As a result, long/short equity funds are generally able to sidestep large drawdowns and compound returns in a more attractive fashion than what is available in the long-only equity world. The universe of long/short equity hedge funds is quite broad with managers in the space implementing the strategy through a fundamental investment approach or by utilizing quantitative methods to arrive at investment decisions. In general, managers who employ a fundamental research approach can be specialists in certain sectors (e.g., technology, healthcare, financials, etc.) or sector agnostic and pursue a more diversified approach.

Nonetheless, the objective of the fundamental long/short manager is to uncover opportunities through deep bottomsup analysis where they aim to identify the intrinsic value of a company. The fundamental investment approach to long/short equity can also be exercised through a single portfolio manager approach where there is a sole risk-taker responsible for initiating and sizing positions or within the context of a multi-manager, multi-strategy structure, which has the potential to offer a more diversified return stream. Alternatively, managers who utilize a quantitative approach to uncovering value in the long/short equity space tend to be broader in nature and seek opportunities across all and any sector through the use of both fundamental and technical factors. Finally, managers within the long/short equity strategy can further distinguish themselves through the levels of gross and net exposure that they are willing to assume, the average duration of their investment holding period, and the market capitalizations of targeted companies.

Long-Short-Equity-7Drivers of returns

The returns of long/short equity managers are determined by the skill of the manager and their ability to successfully navigate the market. By and large, long/short equity managers rely on their stock picking expertise and hedging ability to generate returns.

Success within the space generally hinges on the ability to correctly predict companies that will outperform the market while also discerning the underperformers and shorting them.

The difference between the returns of the long and short holdings is referred to as a “spread” and managers who are able to maximize a positive spread offer a more attractive return profile.

The ability of long/short equity managers to deliver a positive spread is largely related to how they utilize their short portfolio. A long/short equity manager who mostly employs market hedges in their short portfolio is not taking full advantage of the opportunity to extract double alpha.

For instance, at the most basic level, a manager that establishes a short position in an ETF related to U.S. regional banks to hedge a long holding in the sector is largely focused on attempting to reduce sector risks in the name in order to isolate company specific factors as a source of return. Alternatively, a long/short equity manager who views their short portfolio as a source of alpha would seek out individual names deemed to be overvalued in the sector and subsequently implement a short position with the goal of producing a return that outperforms the index and, thereby, enhances the manager’s spread.

Consequently, the ability to extract alpha on the short side requires a particular skillset and is the hallmark of a leading long/ short equity manager.

While an overriding factor, stock selection is not the sole driver of long-term returns for long/short equity managers. Managers pursuing the long/short equity strategy have the ability to augment returns by actively managing the levels of gross and net exposure in the portfolio.

Gross exposure is defined as the long portfolio plus the absolute value of the short portfolio whereas net exposure equals the difference between the long portfolio and the short portfolio.

A long/short equity manager who has the foresight to reduce exposure levels before a market correction is able to protect investor capital and offer an attractive means to long term capital appreciation. Conversely, managers who seek to expose themselves to more market directionality would increase their exposures.

The advantages of long/short equity funds

Better Risk-adjusted Returns than Traditional Equity Portfolios

Over the past 10 years, long/short equity strategy hedge funds have been able to outperform the S&P 500 with significantly less volatility. As illustrated in the chart below, the CS Equity Long/Short HF Index delivered over 100 basis points of outperformance with a standard deviation of 7.84% versus 14.50% for the S&P 500. This translates into a Sharpe Ratio of 0.78 for the CS Long/Short Equity HF Index compared to 0.41 for the S&P 500.

long/short chart1

Potential downside protection in major downturns

long/short chart2It is important to note that long/short equity managers generally run with a low-to-moderate amount of net exposure to equity markets. As a result of operating a hedged portfolio, long/short equity managers typically have not fully participated in runaway bull markets. However, in periods when equity markets faced significant headwinds, the strategy has been able to offer considerable downside protection. For instance, as demonstrated in the table to the right, the CS Equity Long/Short HF Index has historically outperformed the S&P 500 by an average of 9.54% during the 10 worst quarters for the equity markets as long/short equity funds returned on average -4.37% versus -13.91% for the S&P 500. This ability to offer protection during equity market downturns has resulted in more attractive risk-adjusted returns and a superior cumulative growth for the strategy.

Liquidity

Long/short equity managers are recognized for being one of the more liquid hedge fund strategies as they predominantly operate in deep and liquid trading markets. This liquidity generally allows long/short equity managers the ability to quickly adjust exposure levels in order to exploit opportunities or swiftly de-risk the portfolio to sidestep market volatility.

Conclusion

Long/short equity managers have been able to use their flexibility to deliver returns that exceed those available in long-only equity markets and with significantly less volatility. The performance of long/short equity funds is driven by manager skill and the ability to navigate equity markets as compared to long-only managers which typically follow the turbulent path of the overall markets. These long/short hedge funds use their ability to express a negative view on a particular stock, sector or market— along with timely shifts to portfolio exposure levels—to offer enhanced downside protection and the ability to compound returns in a more attractive fashion.

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For more information about the content of this article, please contact John Chatmas at jchatmas@waterloocap.com or call (512) 693-4363.

IMPORTANT DISCLOSURE

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