With uncertain equity markets, the potential for subdued-to-negative economic growth looming, and a bleak outlook for fixed income, advisors are challenged to rethink foundational portfolio 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.

After all, it is a strategy, not an asset class, which invests in equities, and more often than not, does so with net exposure well below 100%; that ends up looking quite similar to a combination of equities and cash or bonds.

A correlation analysis of the return streams for equities, as represented by the S&P 500 Index, and long/short equity strategies, as represented by the Credit Suisse Long/Short Equity Index, reveals that from January 1994 through March 2020, equities and long/short equity strategies exhibited a correlation of about 0.59.

While this is hardly the signature of a truly diversifying asset, it is able to accomplish what diversifying assets are meant to do: improve the risk-adjusted performance of a portfolio.

Consider the following risk and return characteristics using data from Morningstar from January 1, 1994 through March 31, 2020:

Annualized Return

• S&P 500 Index: 9.11% • Barclays U.S. Aggregate Bond Index: 5.47% • 60% S&P 500 Index / 40% Barclays Aggregate Bond Index: 7.94% • Credit Suisse Long/Short Equity Index: 7.23%

Standard Deviation

• S&P 500 Index: 14.69% • Barclays U.S. Aggregate Bond Index: 3.49% • 60% S&P 500 Index / 40% Barclays • Aggregate Bond Index: 8.92% • Credit Suisse Long/Short Equity Index: 6.73%

Sharpe Ratio

• S&P 500 Index: 0.49% • Barclays U.S. Aggregate Bond Index: 0.79% • 60% S&P 500 Index / 40% Barclays Aggregate Bond Index: 0.60% • Credit Suisse Long/Short Equity Index: 0.61%

Maximum Drawdown

• S&P 500 Index: -50.95% • Barclays U.S. Aggregate Bond Index: -3.83% • 60% S&P 500 Index / 40% Barclays Aggregate Bond Index: -32.54% • Credit Suisse Long/Short Equity Index: -19.68%

Long/short equity strategies have come close to matching the performance of equities with a lower level of volatility than the 60/40 stock/bond portfolio, and with smaller drawdowns.

(Note that this was over a time period when the yield on the 10-Year Treasury went from 5.75% to 0.68%, which was unquestionably beneficial to the performance of investment grade debt.)

To be fair, point-in-time statistics can hide a lot, both good and bad. There have been many periods over the last 22 years when investors would have been better off in a 60/40 portfolio, most notably in 2011 when the Credit Suisse Long/Short Equity Index fell by -6.97% and a 60/40 portfolio returned almost 5%.

But here’s the question: Could even the most astute investment professional determine in advance when such time periods will be more conducive to a 60/40 core than for a long/short equity strategy?

We are not stating that long/short equity should completely replace the traditional stock/bond core, but rather it could replace a portion of that core and potentially improve overall performance over the long term through an increased number of alpha sources, while dampening volatility, among other things.

Josh Vail, CAIA, is president of 361 Capital.