From the March 2016 issue of Investment Advisor • Subscribe!

The New Core Allocation: Long-Short Equity

Long-short equity could replace a large portion of the traditional stock-and-bond core while improving overall performance

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Long-short equity can potentially improve overall performance as part of a portfolio's core allocation. Long-short equity can potentially improve overall performance as part of a portfolio's core allocation.

Given the new norm of increased volatility and a bleak market environment, advisors are challenged to rethink the foundational elements of investor portfolios, which means seeking out strategies that bolster the core going forward.

In investing, the “core” has traditionally consisted of developed market equities and investment-grade debt. Increasingly over the last decade, investors — both retail and institutional — have introduced a growing number of diversifying elements to that core, including commodities, floating rate and high-yield debt, emerging market assets and hedge fund strategies, to name a few. Those asset groups have, in portfolio construction lingo, been termed “satellite” allocations.

But not all satellites are distinctly different from core assets. Of all of the satellite strategies, the one that most closely resembles the foundational components of a typical portfolio is long-short equity. It is, after all, a strategy, not an asset class, which invests in equities and more often than not does so with net exposure well below 100%, which ends up looking like a combination of equities and cash or bonds.Correlation Analysis for Equities, Bonds and Long-Short Equity (Source: Morningstar)

A correlation analysis (see table, above) of the return streams for equities, as represented by the S&P 500 Index, and long-short equity strategies, proxied by the Credit Suisse Long-Short Equity Index, reveals that from January 1994 through December 2015, equities and long-short equity strategies exhibited a correlation of about 0.7. This is hardly the signature of a truly diversifying asset, but while long-short equity may fail as a true diversifier, it is nonetheless able to accomplish what diversifying assets are meant to do: that is, improve the risk-adjusted performance of a portfolio.

Consider the following risk and return characteristics.

Long-short equity strategies have, on average, matched the performance of equities with essentially the same level of volatility as a 60/40 stock-bond portfolio, and with better downside protection. (This over a time period when the yield on the 10-Year Treasury went from 5.75% to 2.24%, which was unquestionably beneficial to the performance of investment-grade debt.)

To be fair, point-in-time statistics can hide a lot, both good and bad. There have been many periods over the last 22 years when investors would have been better off in a 60/40 portfolio, most notably in 2011 when the Credit Suisse Long-Short Equity Index fell by 7.3% and a 60/40 portfolio returned almost 5%.

But here's the question: Can even the most astute professional investor determine in advance when such time periods will be more conducive to a 60/40 core than to a long-short equity strategy? We are not stating that long-short equity should completely replace the traditional stock-bond core, but rather it could replace a large portion of that core and potentially improve overall performance, through an increased number of alpha sources, while dampening volatility, among other benefits.

We encourage investors to think of long-short equity as a core position, not as a minor “alternative” allocation floating out among the satellites. It's clear that over multiple market cycles (including two major crashes), long-short equity strategies have outperformed the 60/40 core on a risk-adjusted basis, and the need for such strategies may be even greater today, especially given this new norm.

The starting point, in terms of valuation and fundamentals, is highly predictive of future returns, even if it is silent as to timing. Today's starting point isn't all that promising, as we find ourselves sitting on lofty valuations by historical standards, with a Shiller Cyclically Adjusted PE Ratio of about 24 times earnings versus a long-term average of 16.6, and with interest rates again moving toward their all-time lows, as measured by the 10-year Treasury.

Given those market conditions, as Clint Eastwood might say, “Are you feeling lucky, punk?”

--- Check out "Hedge Fund Investors Optimistic, Will Pay for Quality: Deutsche Bank" on ThinkAdvisor.

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