With the proliferation of so many different “niche” hedge fund strategies, it's no wonder that equity long/short strategies often get bundled into one group. But the reality is that not all long/short strategies are the same, and given the disparate investment styles of the managers running them, many can behave very differently from one another in different market contexts.
A thorough understanding of any particular manager's approach is required to make an informed decision about incorporating the strategy in a portfolio. Here are a few of the ways managers apply their strategies.
Long-biased equity strategies have the most market exposure. It doesn't matter whether the managers are value- or growth-focused, or whether they build their portfolios with a top-down or bottom-up approach — the performance will generally depend on the market's direction.
Other long/ short managers prefer to run a tight net exposure and therefore maintain a higher short exposure. This can be achieved either through fundamental stock picking of individual longs and shorts or pair trading, or by using hedges for additional short exposure.
Some market-neutral managers aim to run with close to zero net exposure to the markets, while others take on some net exposure but try to neutralize certain factors within the portfolio. The calculation of net exposure can be misleading, as some managers can take on significant sector or factor exposures that are not reflected in the overall portfolio exposure levels. There are also some short-biased managers who seek to profit in market dislocations.
Finally, catalyst-focused long/ short managers are more focused on investing in stocks where potential events, such as an acquisition, divestiture or management change, are expected to move the stock price significantly.
WHAT CAN BE EXPECTED
Due to the significant, obvious differences among long/short equity strategies, it is critical that investors understand what to expect of a particular strategy in terms of the manager's investment style, risk discipline and estimated performance across market environments.
The proper use of various long/ short strategies within a broader portfolio will ultimately depend on the objectives and composition of that particular portfolio. If the rest of the portfolio is composed of traditional equity and fixed-income allocations, adding less-directional long/short equity strategies could provide a nice complement in a volatile market. Long-biased long/short strategies are sometimes used within a portfolio's equity allocation, whereas more market-neutral strategies sometimes reduce the bond allocation.
In short, long/short strategies and alternatives can provide a “third leg of the stool,” to act as a diversifier and dampen the volatility of a portfolio.
In today's market environment, many advisers and investors are concentrated on allocating to event-driven and activist managers for the long/ short equity component of their portfolios. Such a move can provide exposure to potential upside in the equity markets, and because these strategies rely on idiosyncratic catalysts in the companies they own, they aren't as dependent on market direction for returns.
These managers' investment theses are based on company-specific events, such as buybacks, mergers and acquisitions, and spinoffs, that can drive up stock prices.
The environment for these strategies has been very fertile. Companies are under intense pressure to deliver shareholder value, which has led to a surge in M&A volume this year, in addition to more divestitures, buybacks and dividend announcements.
The decrease in stock correlations has been a tail wind for these strategies as stocks are rewarded on their own merits.
Dorothy Weaver is principal, chairman and CEO of Collins Capital.