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.
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.)