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:
• 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%