We all know that extreme confidence in the direction of the market is a rare and fleeting phenomenon. Today, however, for any number of good reasons, not least of which the so-called “fiscal cliff,” many financial advisors find themselves in a gut-wrenching conundrum.
On the one hand, they know that equity exposure is the best way to gain long-term returns for their clients. On the other, the ability of Congress and the White House to develop a thoughtful compromise could be the difference between 2013 being a good year for equities or a challenging one. Most advisors will be forgiven for feeling less than confident in the short-term outlook. One option to consider for implementing some portion of your equity portfolios in this uncertain environment is an equity long/short fund. A well-executed long/short fund can deliver equity exposure with less risk.
Warranting a Closer Look
In the broadest definition, long/short equity strategies involve buying stocks that are expected to increase in value and selling stocks that are expected to decrease in value. In practice, long/short managers construct portfolios by purchasing or synthetically going long securities and selling borrowed securities or synthetically shorting securities. The manager, in other words, is in some form betting for and against equities at the same time.
While long/short equity funds are often classified as “alternatives” exposure, they should more appropriately be thought of as equity with muted beta. While it is true that a talented manager can add value in both their long and short book, most managers tend to be more long than short so they will have a ‘net long’ position when the value of the two are combined. The tendency to be net long means that a long/short fund will likely have a fairly positive correlation to the market. In other words, if stocks are up, the fund will most likely be up; if stocks are down, the fund will most likely be down. However, because these funds will have a net exposure less than 100% to the market, they should be up less and down less. This is why we suggest thinking of them as muted equity beta.
Beyond the reduced beta, well-executed long/short funds can offer two other advantages in the current environment. First, if they can add value in their short book, the fund has the ability to do better than the beta would suggest they should do in either an up or down market. Second, some funds will adjust the beta of their portfolio (by buying or shorting more or less stocks) based upon their current read of the markets. In other words, the manager can help you make tactical equity exposure decisions on a day-to-day basis. If the manager is able to deftly guide the net exposure of the portfolio up and down through rallies and downswings it can result in the best of both worlds.
Of course, there is no such thing as a free lunch. First and foremost, there is no guarantee that the manager of a long/short fund can skillfully deliver on any of the above. Further, there are certain risks associated with the use of leverage or short-selling that are not present in a traditional long-only fund. The same additional levers that make long/short managers attractive also mean there is more complexity in evaluating, choosing and monitoring one.
Standing Out In a Small Crowd
In choosing a long/short equity strategy, there are single manager mutual funds as well as funds-of-funds options. Single manager funds tend to offer a higher level of transparency and accountability, but also introduce idiosyncratic risk. Funds-of-funds reduce the idiosyncratic risk by offering diversification; however, the fees tend to be higher. Either way, you’ll want to pay attention to fees – the average expense for the long-short category as a whole is higher than that of U.S. stock funds. By number, they’realso still relatively rare in the mutual fund world, with less than 100 publicly offered funds.
Among that relatively short list, the research team at Envestnet | Prima has recently added one long/short fund to its Select lineup: The Robeco Boston Partners L/S Research Fund (BPIRX). A single manager strategy, the Robeco Fund represents what we consider to be a ‘best-of-breed’ long/short offering. The manager's ability to blend quantitative research with fundamental analysis, allocate capital across market capitalizations, and actively manage the fund's beta exposure depending on the current market environment are key value-adds for shareholders.
Long/Short for the Right Reasons
From a strategic perspective, long/short equity strategies could be used to reduce volatility in the equity sleeve of a portfolio while providing less correlated returns to traditional long-only strategies. On a more tactical basis, long/short equity strategies can be used when an advisor feels that equity valuations are rich and shorting would add value when prices fall. In either case, it should be noted that net and gross exposures among long/short managers can vary widely, and this reality should be taken into account.
In today’s uncertain market environment, we have to think that the best long/short equity funds will be those that can nimbly increase and decrease their net exposure while adding value in both their long and short book. The goal is to get most of the market's returns when stocks go up, while limiting losses when they go down. Bottom line: adding a long/short equity manager to your clients’ portfolios right now will not be the answer to all of the market symptoms related to the fiscal cliff, but such a move could bolster client’s equity exposure while attenuating the risk.
Author’s disclaimer: Past performance is not indicative of future results. The opinions expressed herein reflect our judgment as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation. Investment decisions should always be made based on the investor’s specific financial needs and objectives, goals, time horizon, and risk tolerance. Information obtained from third party resources are believed to be reliable but not guaranteed. Any mention of a specific security is for illustrative purposes only and is not intended as a recommendation or advice regarding the specific security mentioned.