Economic and political uncertainty continues to drive volatility, leading investors to search for strategies that can provide a smoother ride — one that attempts to build and preserve capital.
The current macroeconomic environment is a struggle between the developed world's deflationary-debt pressures and the unprecedented inflationary stimulus that has been the response from global central banks. Investors should not be lulled into complacency amid low interest rates and a slow-growing economy.
Volatility is here to stay, as slow growth means a smaller margin of safety for the economy. Consequently, investors should plan for volatility in securities prices and include in their allocation a flexible vehicle that can react quickly in up as well as down markets.
Funds that have the ability to invest long, short and in fixed income may provide a flexible portfolio that can respond rapidly to market conditions by managing exposure and reducing risks.
On the long side, it's essential to have a deep understanding of the companies owned and a sense of the key factors that may move those securities.
Capital is allocated only when qualified investments are found and if potential rewards exist for taking risks. In today's environment, the search is on for companies that have believable, low-risk growth strategies or that can supply sustainable income streams to shareholders. That may include using fixed-income investments.
RETURN FOR RISK
What makes a fixed-income security “work” as an investment generally is different from a stock. Fixed-income research has to concentrate on factors such as the ability to generate free cash flow, a demonstrated commitment to use that cash to pay down debt and an improving credit profile.
While the fixed-income universe is broad, seek to identify bonds that are expected to provide a reasonable return for risk.
Consequently, in this low-interest-rate environment, fixed-income exposure should center on securities that appear less sensitive to interest rate risk, and on fundamentals and improvements in the balance sheet.
Shifting gears, shorting is a tool with the potential to increase returns and/or reduce risk, particularly in uncertain market environments. Specifically, enhanced returns may come through company-specific short positions that appear disadvantaged or poorly positioned based on fundamental research.
These short positions tend to be related to a specific event or trigger that could affect the price of a security held in the portfolio for a shorter time than fundamental long holdings.
Risk also may be reduced through “market” shorts on specific markets, sectors, geographies or market capitalizations. This is typically implemented through futures, exchange-traded funds or options.
Building a portfolio, it's important to be not only a bottom-up stock picker, but also “macro-aware.” That means monitoring credit markets and paying attention to the direction of high-yield credit spreads. Credit investors are always intent on what could go wrong, and there is merit to the notion that credit leads equities.
Watching equity risk premiums, as well as assessing daily and intraday market movements and the portfolio's real-time behavior, are key to the strategy. In this regard, portfolio behavior will be consistent with expectations. In short, respect volatility, because it means that uncertainty surrounding earnings is rising.
Ultimately, historical and continuing keys to success for a long-short strategy rely on security selection, risk management, and getting gross and net exposures right. The gross exposure of a long-short portfolio is calculated by adding the percentage of the capital used for long positions with the amount invested in short sales. Net exposure is the long percentage minus the short one. Gross exposure should be reduced first during times of significant uncertainty.
Continued volatility reinforces a belief in the benefit of a long-short strategy that strives to increase the chance for gains while limiting downside risk via an expanded investment tool kit.
That said, there's a big safety margin in risk assets for investors able to maintain a longer-term view. The U.S. economy's structural challenges will correct over time.
Charles Kantor is a managing director of Neuberger Berman Group LLC and portfolio manager of the Neuberger Berman Long Short Fund.