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It’s a Stock Picker’s Market Now

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After five years of disappointing returns, long-short equity hedge funds are rallying. They finished 2012 in positive territory and their performance so far in 2013 has been encouraging. That’s good news for investors in alternative investments. Long-short equity hedge funds make up one of the biggest alternative investment asset classes, with north of $170 billion in assets, according to alternatives performance monitor BarclayHedge. Their classic hedging techniques, the very ones that spawned the alternative investments industry more than 60 years ago, have the potential to preserve capital in a market downturn or at least mitigate losses. Elite-level stock selection, skilled shorting, and low market exposure and leverage are among the key attributes investors seek when allocating to the strategy.

At the same time that long-short equity hedge funds have been rallying, the so-called intrastock correlation has been falling. What’s the connection? Intrastock correlation measures the degree to which stocks move in lockstep synchronization. The closer to 100% the correlation, the more stock prices move together. When correlations are high, it doesn’t matter if the ABC widget company has better prospects than its competitor, XYZ–they both move in tandem.

High correlations are problematic for long-short equity hedge funds. Fundamental analysis, the heart and soul of long-short equity fund managers, gets eclipsed by more irrational market forces. No matter how well they crunch the numbers, stock pickers can’t fight the high-correlation headwinds. While theories abound about why correlations have been so high, clearly one explanation is the macroeconomic world we have been living in since the 2008 financial crisis. Government heads and central bankers have had unusually strong influence over financial markets, and politics have been more important than either economics or stock-picking.

There are still plenty of macroeconomic worries, but they appear to be subsiding. The European Union is committed to bailing out its weaker members, the U.S. economy is recovering, and record low interest rates have, so far, not fueled inflation. The signals thrown off by the intrastock correlation suggest that these macro worries began fading in mid-2012 when correlations began falling and micro issues re-emerged. It’s now, when correlations are low, that we see a greater diversity in stock returns, and long-short equity hedge fund managers get to show their stuff.

The accompanying chart shows the pair-wise correlation: the tendency of each stock in the S&P 500 to move in concert, or not, with every other stock in the index on an intraday basis. As you can see from the chart, pair-wise correlation has historically hovered between 10% and 40%. In the years since the financial crisis, the correlation has leaped to 60% and even 70%, peaking in October 2011. Only recently have the numbers returned to their usual position. We are still not firmly below the 30% level, but the trend seems to be going in the right direction.

While falling correlations help long-short equity hedge fund managers, it’s not enough. Stock selection is key to the long-short equity strategy. Not all hedge fund managers are equal and selecting the right manager is particularly tricky. Let me give an example.

Imagine two hedge fund managers who are both pursuing a long-short equity strategy. Both are long and short technology companies with large market capitalizations, but their long and short positions in two companies are mirror images. I won’t give the names of the companies, but their stock histories are real. Hedge Fund Manager A is long a company we’ll call ABC and short a company we’ll call XYZ. Hedge Fund Manager B is taking the opposite position–long XYZ and short ABC. In the six months between September 2012 and March 1, 2013, ABC stock gained 5.20% in value while XYZ stock lost 26.81%. They employed the same general long-short idea, but had radically different applications and results.

Multiply that example and it’s easy to see why the range in performance between the top and bottom performers—or so-called performance dispersion–can be so large among long-short equity hedge fund managers, and why it’s important to pick managers in the top quartile. Long-short equity has seen a far greater historical dispersion in manager performance than long-only equity.

With the stock market flirting with new highs, advisors are naturally looking at ways to protect their clients’ capital if there’s a correction. Long-short equity hedge funds are a viable option for that objective, but if the intrastock correlation keeps falling and it continues to be a stock picker’s market, the emphasis is going to be on the manager’s stock selection skills, especially on the short side. The next phase of the market could separate the skilled long-short equity hedge fund managers from the wannabes.