Net exposure: The long and short of it

Investors and their advisers are nervous. Stocks are hovering near record highs while bond yields have moved slightly above record lows. One response from investors, both institutions and individuals, has been to reduce their risks by increasing their allocations to long/short strategies. That’s a major reason why hedge funds have seen assets under management top $2.3 trillion, a new high, despite their underperformance versus the S&P 500. This is also why demand for liquid alternative funds, vehicles that combine mutual funds’ low minimums and daily liquidity with hedge funds’ shorting capabilities, soared in 2013, with assets up nearly 44% in one year to $132 billion, according to Morningstar Inc..

With memories of 2008 still fresh for many, reducing risk should be as important as reaping rewards. Even if it means generating lower returns in a given year, many investors would rather have a smoother return profile than ride the market’s roller coaster. True long/short hedged strategies potentially can reduce one’s dependence on major timing decisions for asset reallocation, and can be one of the most effective ways to minimize gut-wrenching dips and produce reasonable returns over most investors’ time horizons.

Long/short strategies now are available for just about every sector of the financial markets. However, when it comes to actively managed funds, not all long/short managers are created equal. Shorting is a rare and difficult skill. I speak from experience. I have observed many managers who could handle the technicalities, the research and the psychological requirements of being on the short side of markets and many very capable long-only managers who could not. Conducting a little due diligence can help sort the skilled from the unskilled and determine the risk one is taking. I would start with understanding the history and experience of the manager. This applies to both single manager and multimanager funds. Then I would delve into the characteristics of the specific funds, starting with their net exposure.

Simply put, net exposure is the difference between a fund’s long positions and its short positions. If 60% of a fund is long and 40% is short, the fund’s gross exposure is 100% (60%+40%) and its net exposure is 20% (60%-40%), assuming that the fund uses no leverage.

As an example, one of the best-performing equity hedge funds in 2013 posted a 27.7% gain and had a reported average net exposure of 72%. This fund used minimal or no leverage. Assuming no leverage, a 72% average net exposure means that, on average, 86% of its portfolio was long and only 14% was short. That net exposure reveals that the managers of the fund likely had a bullish outlook for 2013. If the managers believe markets will suffer in 2014, they will most likely increase their short positions and reduce their net exposure. Looking at how the net exposure has varied over the years and its impact on returns gives a good indication of the managers’ commitment to and expertise on the short side and the funds’ likely exposure to swings in the market.

Another way to assess the skill of managers is to determine if the individual security selections on both the long and short side actually contributed to the performance of the fund. Did the long and short positions do better than the indexes against which they were measured?

When considering a long/short fund, it’s important to understand the tools the managers use to create hedges. Today, there are a variety of ways to short in a portfolio, ranging from individual securities to buying put or selling call options on securities and indexes to more sophisticated approaches using credit default swaps and other derivatives. These technicalities have different degrees of risk, requiring skill and experience from the managers.
Finally, due diligence can determine how much managers borrow to increase leverage on the long side. A leveraged fund is not necessarily a hedge fund even though it often gets categorized as such. Unless the leverage is offset with appropriate hedging, it can simply magnify gains and losses in rising and falling markets. Determining the volatility, the possible losses the managers are willing to tolerate becomes a real consideration if the investor may not have the same degree of tolerance.
Long /short funds are powerful tools to mitigate risk and produce returns, and I believe will be of particular value in the markets we are likely to experience over the next few years. These funds can play an important part in meeting risk and return objectives. But investing in them successfully requires the specific answers from the managers to the issues raised above. Don’t hesitate to seek these answers.

Jack L. Rivkin is chief investment officer of Altegris

Related Topics: Asset Allocation, Risk Management