Outside-IN

Outside-INblog

Outside voices and views for advisers

The long/short case for investors

Balancing equity risk with capturing decent returns is always difficult and these strategies could help, especially today with liquid alternatives

Mar 17, 2015 @ 12:01 am

By Juliana Hadas and Andrea Pompili

The task of balancing equity risk with the goal of achieving meaningful returns is top-of-mind for many investors and advisers. Long/short equity strategies, which allow managers to assume both long and short positions and to vary their exposure to the equity market over market cycles, may fill this role.

The introduction of liquid alternative funds allows investors access to long/short strategies in a mutual fund format.

There are four key reasons to consider an allocation to long/short strategies:

1. Unlock different sources of alpha

2. Reduce equity beta risk

3. Improve return/risk profile of an equity allocation

4. Access through “liquid alternative” funds that offer daily liquidity, lower fees and more transparency.

(More: Reading between the lines of liquid alternatives fund expense ratios)

UNLOCK DIFFERENT SOURCES OF ALPHA

The ability to engage in short-selling increases the opportunity to generate alpha from security selection. Without an ability to short, a negative view on a security can only be expressed by not holding that security, and the magnitude of the underweight relative to the index is limited to the security's weight in the benchmark. For many securities, this weight amounts to mere basis points. The ability to short eliminates such constraints. The ability to short, thereby hedging out some market risk, also enables long/short funds to take bigger positions in their higher-conviction long ideas compared to more constrained long-only strategies.

Long/short funds also have greater flexibility to deviate from an equity benchmark in terms of the portfolio's size and style focus. This flexibility can allow long/short funds to better take advantage of a manager's security, sector or region expertise compared to a portfolio that is benchmark-constrained.

Empirical evidence suggests that security selection skill on the long side can add meaningfully to performance. There is less data available to analyze the effect of security selection skill on the short side, but anecdotal evidence suggests that alpha generation capabilities on the short side vary substantially by manager.

To determine the magnitude of security selection skill on the long side of hedge fund portfolios, we examined the universe of stocks owned by hedge funds, as proxied in their 13F filings (Securities and Exchange Commission Form 13F lists investment managers' holdings). We created a monthly return series, from June 2000 through December 2014, dollar-weighting all stocks that appeared in 13F filings. Since the filings cover primarily U.S. exchange-traded stocks, we compared the series to the Russell 3000 U.S.-listed all-cap universe. Over this time period, the 13F universe outperformed the index in 60% of the months, by an average of 32 basis points per month. Compounded, this represents an annualized 3.6% in excess returns.

REDUCE EQUITY BETA RISK

Short exposure, when used to balance long exposure, works to reduce market risk. In addition, long/short funds are able to hold cash in their portfolio, with fewer constraints than is the case for more benchmark-constrained long-only managers. These two factors help reduce beta and volatility. While long/short funds have tended to underperform equity markets in strong, sustained bull markets, they have achieved attractive risk mitigation in down markets compared to long-only benchmarks.

(More: The long and short of it: Strategies not the same)

Generally, beta and net exposure have been higher in strong markets and lower in challenging markets. In this way, long/short managers can be viewed as engaging in tactical asset allocation.

IMPROVE RETURN/RISK PROFILE

Historically, long/short funds have achieved better risk-adjusted performance over market cycles than long-only managers and benchmarks, generating equity-like returns with about half the volatility of equity markets.

In this way, the universe of long/short funds has used its equity risk capital more efficiently than has the universe of long-only managers or broad equity benchmarks. Including long/short funds in a portfolio, therefore, has the potential to improve an investor's overall return/risk ratio.

LIQUID ALTERNATIVES

Increasingly, hedge fund strategies are available in retail fund vehicles, such as U.S.-registered mutual funds ('40-Act funds), providing much wider access to hedge fund strategies. The mutual fund structure has significant benefits in terms of liquidity, fees and regulatory oversight compared with most unregistered hedge funds. Daily liquidity at a fund's net asset value can aid investors in tactical portfolio rebalancing and help limit illiquidity in a crisis event. It can also free up a portion of the investor's illiquidity budget for other strategies that may not lend themselves to daily liquidity but may have the potential to offer a significant illiquidity premium.

While higher than many traditional long-only mutual funds, fees charged by liquid alternative funds are typically lower than those on traditional hedge fund vehicles. Unlike traditional hedge funds, most mutual funds do not charge performance-based fees.

In addition, compared with traditional hedge funds, liquid alternative funds offer greater transparency of portfolio holdings, limitations on the use of leverage and strict liquidity requirements.

ALLOCATION CONSIDERATIONS

Given the nature of long/short strategies and their high correlations to equity markets, investors may wish to consider long/short funds as equity implementation vehicles alongside long-only funds. The “optimal” allocation to long/short funds is largely a function of an investor's risk appetite in equity markets and tolerance for risk during market downturns.

Manager skill is critical in a successful long/short investment program. The fewer constraints on investing, the larger the potential magnitude of positive or negative performance. Returns dispersion among individual managers is substantial.

Long/short equity can play an important role in a portfolio's equity allocation, with the potential to reduce equity risk exposure, improve the overall risk-return profile of a portfolio, and unlock additional sources of alpha compared to more benchmark-constrained long-only equity strategies. While long/short fund investing entails unique risks, historically long/short funds have achieved equity-like returns with less volatility than equity markets via a combination of security selection and asset allocation skill.

Juliana Hadas and Andrea Pompili are in Neuberger Berman's Investment Strategy and Risk Group.

0
Comments

What do you think?

View comments

Recommended for you

Sponsored financial news

Upcoming Event

May 02

Conference

Women Adviser Summit

The InvestmentNews Women Adviser Summit, a one-day workshop now held in four cities due to popular demand, is uniquely designed for the sophisticated female adviser who wants to take her personal and professional self to the next level.... Learn more

Featured video

INTV

When can advisers expect an SEC fiduciary rule proposal and other regs this year?

Managing editor Christina Nelson and senior reporter Mark Schoeff Jr. discuss regulations of consequence to financial advisers in 2018, and their likely timing.

Recommended Video

Path to growth

Latest news & opinion

Cutting through the red tape of adviser regulation is tricky

Don't expect a simple rollback of rules under the Trump administration in 2018 — instead, regulators are on pace to bolster financial adviser oversight.

Bond investors have more to worry about than a government shutdown

Inflation worries, international rates pushing Treasuries yields higher.

State measures to prevent elder financial abuse gaining steam

A growing number of states are looking to pass rules preventing exploitation of seniors.

Morgan Stanley reports a loss of advisers after exiting the protocol for broker recruiting

The firm said it lost 47 brokers in the fourth quarter, the most in any quarter of 2017.

Morgan Stanley's wealth management fees climb to all-time high

Improvement reflect firm's shift of more clients into fee-based accounts priced on asset levels, which boosts results as markets rise.

X

Hi! Glad you're here and we hope you like all the great work we do here at InvestmentNews. But what we do is expensive and is funded in part by our sponsors. So won't you show our sponsors a little love by whitelisting investmentnews.com? It'll help us continue to serve you.

Yes, show me how to whitelist investmentnews.com

Ad blocker detected. Please whitelist us or give premium a try.

X

Subscribe and Save 60%

Premium Access
Print + Digital

Learn more
Subscribe to Print