Liquid Alts, Pt. 1: The Long and the Short of Them

Long-short equity strategies include long-biased strategies such as 130-30 (a strategy in which a manager invests 130% of the portfolio in long investments while having short positions equal to 30% of the portfolio) as well as strategies that typically hold more long positions than short positions, but have less than 100% market exposure. 

Long-biased strategies typically are used in equity allocations, providing exposure by either taking advantage of a manager’s ability to identify both long and short selling opportunities or by providing equity exposure that is designed to be less volatile than that of the market. Many of the strategies are promoted as providing less risk than the market, though they are still directionally correlated with the market. 

Equity market neutral funds invest in offsetting long and short positions, hedging market risk while providing absolute returns designed to be independent of the direction of markets. Many market neutral managers utilize quantitative strategies to identify long and short positions in equities and their derivatives with offsetting risk characteristics.  Market neutral strategies are often used as fixed income substitutes, as the risk/return profile provides bond-like attributes while diversifying portfolio risks. 

We are supporters of the conceptual reasoning behind equity market neutral strategies, but caution investors to understand that a manager can at times be wrong about both the long side of a trade as well as the short side, creating risk that, though theoretically uncorrelated with the market, can still carry a significant risk of capital loss.

Short selling or bear market strategies have a net short position and are designed as portfolio hedging tools. Many bear market funds are more suitable for short-term trading than for long-term ownership. 

Event-Driven Strategies

Event driven strategies include merger arbitrage, activist and restructuring-oriented investments.  Merger arbitrage strategies are easier to provide in liquid form and represent the majority of event-driven assets offered in 1940 Act products.  Activist and restructuring-oriented investment are more difficult to deliver in registered products, as the concentration or illiquidity found in the typical private hedge fund product is harder to replicate in a mutual fund or ETF.

Merger arbitrage strategies typically invest in stocks that are the target of an announced stock for stock transaction, while selling short the stock of the acquirer. Some aggressive merger strategies will also invest to take advantage of unannounced but suspected transactions based on investment research. In all-cash deal,s merger arbitrage funds buy the target stock while shorting calls of the acquirer. Conceptually, merger arbitrage investors seek to capture the premium paid for the target. 

Merger arbitrage strategies are often used as fixed income substitutes, providing steady risk-adjusted returns in normal market environments. Merger arbitrage strategies can struggle in times of crisis when deal flow dries up, when deals are more likely to fall through or when financing costs unexpectedly rise.  

In part two of our series, we’ll look discuss long-short bond strategies, macro strategies, and provide some thoughts on how to select a liquid alternatives product.