It's easy to argue that investment flexibility is needed now more than ever. New market highs and stretched valuations, ongoing nonsense in Washington and a less accommodative Fed could be detrimental to even the best laid investment plans. That's among the reasons long/short equity is by far the largest of the single-strategy alternative mutual fund categories tracked by Morningstar.
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In periods of equity market uncertainty and dwindling returns for fixed income, investors use long/short equity strategies to capture equity-like returns while managing downside risk, and find it appealing for several reasons:
1. Managers can dampen volatility and help mitigate the possibility of a large loss. For example, the maximum drawdown for the HFRI Hedged Equity Index was 29.5% during the financial crisis, while the S&P 500 experienced a drawdown of 50.9%.
An investor who experienced the loss of the HFRI index needed to generate a return of approximately 42% to get back to even, whereas an investor in the S&P 500 required a return of 104%. While a 29.5% loss is horrendous, climbing out of that hole is far less daunting than what long-only investors faced.
Clients don't have the luxury to wait to earn the “average” returns offered by the long term. With only a few decades to save for retirement, a prolonged period of low real returns can be detrimental.
2. The ability to go long or short provides the ultimate investment flexibility. When long-only managers come across a security with a lower expected risk-adjusted return profile they can underweight it or avoid it. Long/short equity managers have greater flexibility: A security with superior characteristics is purchased, a security with a poor outlook is shorted, and a security with a market-like payoff is put aside until either valuation or fundamentals turn it into a higher conviction long or short position. Greater efficiency is possible because everything uncovered during the research process can be acted upon. Further, there can be additional sources of alpha, namely the short book and decisions that increase or decrease overall net exposure.
3. Liquidity is less of a concern in long/short equity strategies compared to many other alternative strategies. It's no secret that size is the enemy of all investment strategies: The more assets raised, the harder it is to put those assets to work without lowering the portfolio's return potential. Long/short equity is no exception, but global equity markets are deep enough to mitigate liquidity concerns until a fund raises several billion dollars.
Even so, it's necessary to consider the overall liquidity profile of each manager during the underwriting process.
Equities continue to exhibit lofty valuations by historical standards, with a Shiller Cyclically Adjusted PE Ratio of about 30 times earnings versus a long-term average of 16.7 as of June 30. Further, interest rates remain near their all-time lows, as measured by the 10-year Treasury.
While equity valuations can reside far from their means for extended periods, bond valuations expressed in current yields are more predictive of near-term returns for investment-grade debt, a key component of the typical core portfolio. With that in mind, let's explore the potential pathways for rates.
Closer to Zero
Over the medium term, the best predictor of bond market returns, as measured by the Bloomberg Barclays Aggregate Bond Index, is the yield at the time of investment. As of June 30, that yield was about 2.6%.
An estimate of future inflation, based on a model that combines the inflation forecast from the Philadelphia Fed's Survey of Professional Forecasters and the implied breakeven rate of inflation between nominal Treasuries and TIPS, suggests that inflation will run around 2.3% over the next five years.
Therefore, even without a rise in interest rates, the best investors can reasonably hope for is a return of close to zero on a real basis (i.e., 2.6% - 2.3% = 0.3%).
It gets worse if rates rise. Long-term corporate and government bonds suffered four consecutive decades of negative real rates of return beginning in the 1940s.
Investors need to improve upon the return potential of an investment-grade debt portfolio without taking excessive equity risk. Adding long/short equity while reducing both long-only equity and investment-grade debt does just that. Over multiple market cycles (including two major crashes), long/short equity strategies have outperformed the 60/40 core on a risk-adjusted basis. In a market environment that portends low future returns, every basis point counts.