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.