A new paper from Neuberger Berman, an employee owned private investment firm that’s been part of the New York scene since 1939, makes the case that long/short equity strategies are “worth consideration as part of an investor’s equity allocation and the overall investment mix.”
The paper is written by Juliana Hadas, CFA, and Andrea Pompili. It focuses on long-biased L/S funds, in contrast either to market neutral or short-biased funds.
There are four reasons such strategies merit such consideration:
- They unlock different sources of alpha,
- Reduce equity beta risk
- Improve return/risk profile, and
- Can be accessed through liquid alternative fund structures that offer daily liquidity, lower fees, and transparency.
Two indexes are employed for purposes of this discussion, the HFRI Equity Hedge (Total) Index from Hedge Fund Research Inc., and the Long/Short Equity Index from Credit Suisse. The former is equally weighted by fund, the latter is asset weighted.
Readers of AllAboutAlpha will need little exposition of the first item on the Hadas-Pompili list. Shorting a stock is the most obvious way to play a speculation that the stock in question will fall in price, and at the same time it helps with the hedging of long bets, enabling the pursuit of alpha on both sides. Also, of course, a long/short manager can go more than 100% long by leveraging the proceeds of its short sales. With that said, let’s proceed directly to the second item.
Reduction of Beta Risk
The reduction of beta risk comes about because betas on the short side offset those on the long side.
Under this heading, Hadas and Pompili naturally consider the question: how long-biased are long-biased L/S funds? The short answer is that they typically have a net exposure on the long side of between 30% and 60%. But the long-form answer is that this exposure varies inversely with the volatility of the equity markets. Exposure was below 80% for much of 2007, but as the global financial crisis drove up volatility, exposure levels collapsed, judging from a cross-section of representative funds exposure got almost as low as 20%.
Though exposure soon recovered (turning the corner quite early in 2009) it has suffered analogous collapses since, again correlated with equity vol, in each of the next three years: 2010, 2011, 2012.
Long-short funds “tend to underperform equity markets in strong, sustained bull markets, but are able to mitigate downside risk and outperform in market downturns.”
Improving the Profile
Past 10 Years Return and Volatility
Adapted from Fig. 4, Neuberger Berman, “The Case for Long/Short Equity,” source, HFR, Credit Suisse, Russell, MSCI. 10-year monthly data through September 2014. Hedge fund index data in U.S. Dollars; long-only index data in local currencies. U.S. equity data proxied by the Russell 3000 Index; Global, Developed Market and Emerging Market data proxied by MSCI’s ACWI, EAFE and EM Indices, respectively.
The above graph shows the returns as the Y values and the volatility as the X values for six benchmarks. It is accompanied of course with the bold-faced reminder that “past performance is not indicative of future results.”
The over-all risk-return profile achievable with L/S equity is better than that available to long-only funds. These authors cite 10 year monthly data from both the HFR Equity Hedge and Credit Suisse Long/Short, the leftward most two points on the graph. Both show the annualized vol of L/DS funds at safely in the realm of single digits.
Indeed, such results have been behind the push in recent years to create liquid alternatives, structures that provide much broader access to long/short strategies. The availability of such funds is itself the fourth reason for considering the strategy. Even for investors who do have some stomach for illiquid strategies, these vehicles can “free up a portion of the investor’s illiquidity budget” for other strategies that may include a significant illiquidity premium.
The authors observe, too, that “fees charged by liquid alternatives are typically lower than fees on traditional hedge fund vehicles.”
Another point: liquid alternatives are a good deal more transparent than hedge funds proper, on positions, leverage, and valuations. This will appeal to the investors who want a granular understanding of their portfolios.
Two Major Challenges
The return of L/S equity strategies has been impeded somewhat of late by two great challenges. The first: from the global financial crisis until 2012 the world market displayed an unusually high correlation among stocks. Movements were shaped “more by macroeconomic developments and overall market sentiment” than by the fundamentals of individual enterprises.
This is a difficulty for all funds that rely on stock picking, and stock picking is in turn usually an element in the creation of the portfolio of an L/S equity fund.
The second challenge: interest rates have been at historically low levels since the crisis. Low interest rates reduce valuation dispersion in the market, which again reduces Jensen’s alpha.
But the authors expect that the worst of each of these challenges is already in the rear view mirror. Alpha from L/S equity “has been rebounding starting with the second half of 2012 – a trend we believe will continue.”