Hedge funds take the ‘short’ out of long-short strategy

What happens when you take the “short” out of a long-short trading strategy? Some hedge funds are about to find out.

Equity long-short fund managers, the biggest category in hedge funds, hold the fewest bearish stock bets on record, data compiled by Credit Suisse Group AG show. The shift reflects their abysmal performance in 2016, when the S&P 500 advanced 9.5% as the long-short managers tracked by Credit Suisse fell 4.3%, their worst year since 2011.

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With the market continuing to rally, many hedge funds have decided to toss the short side of these pairs and stick with the long side to avoid getting singed in a hot market.

“Risk is to the upside,” Mark Connors, Credit Suisse’s global head of risk advisory in New York, said by phone. “People want to get involved.”

Money managers who use long-short strategies try to minimize the impact of market moves or add leverage to their positions by pairing trades, matching a long position in a stock expected to rise with a short position in one expected to fall. The portfolios typically are designed with a “long bias,” meaning they’re expected to capture a climbing market while providing some protection if things fall apart.

Investors have spent the new year grappling with evidence that stocks may have run too far. Traders added $1.7 trillion in market value to U.S. equities since the election. Meanwhile, the S&P 500 wandered into the overbought range for five straight trading days in December, as judged by its relative strength index, the longest stretch since September 2014.

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But as money managers increasingly focus on long stock positions they could help carry the rally further. Equity long-short hedge funds had $686.7 billion assets under management as of November 2016, the most among the categories tracked by eVestment. And they have plenty of cash available to put to work since long positions are 20 percentage points below their five-year average, according to Credit Suisse.

Still, there’s no guarantee that equity long-shorts will catalyze the next leg of the rally. The funds have yet to add significant long bets, a sign of the group’s tepidness. The thinking is, if there’s a change in fortune for U.S. stocks, it’s easier to re-up short positions than to ditch the longs.

This kind of skepticism, however, created their messy 2016 in the first place. Long-short funds failed to latch onto the rally in value stocks, holding onto their short bets on energy stocks as shares bounced back from their Feb. 11 low. Brexit and a risk rotation in November also hurt the funds, Connors said.

These diverging factors help explain why long-short managers are taking disparate approaches. It’s apparent in the unequal returns from 2016, when the top performing funds pulled away from their weaker rivals. Though the average manager took a hit, the top quartile returned 5.1% while the bottom fell 7.9%, Credit Suisse data show.

“Like the wealth disparity grew,” Connors said, “so have the returns in hedge funds.”