The Case For Long/Short Equity: Four Reasons To Include The Strategy In A Portfolio by Juliana Hadas, CFA and Andrea Pompili, Neuberger Berman
The task of balancing equity risk with the goal of achieving meaningful returns is top-of-mind for many investors. The search is on for strategies that can fill this role, whether through asset allocation or choice of securities within the equity space. Into this fray appear long/short equity strategies, which allow managers to assume both long and short positions in their ideas and to vary their exposure to the equity market over market cycles. We believe that long/short strategies, with their risk-managed alpha generation potential, are worth consideration as part of an investor’s equity allocation and the overall investment mix.
In our view, there are four key reasons to consider an allocation to long/short equity strategies:
- Unlock different sources of alpha
- Reduce equity beta risk
- Improve return/risk profile of an equity allocation
- Access through new, “liquid alternative” fund structures that offer daily liquidity, lower fees and more transparency.
The universe of long/short funds can be subdivided into three main sub-strategies: long-biased (funds that hedge out some, but not all, market beta), equity market neutral (funds that hedge out all market beta and focus exclusively on alpha generation), and short-biased. The focus of this paper is long-biased long/short funds.
Long/Short Equity In A Portfolio – Reason #1: Unlock Different Sources Of Alpha
The ability to engage in short-selling increases a portfolio manager’s opportunity to generate alpha from security selection. Without an ability to short, a negative view on a security can only be expressed by not holding that security, and the magnitude of the underweight relative to the index is limited to the security’s weight in the benchmark. For many securities, this weight amounts to mere basis points. The ability to short eliminates such constraints. By hedging out some market risk (beta), shorting also enables long/short funds to take bigger positions in their higher-conviction long ideas compared to more constrained long-only strategies. Furthermore, a long/short manager can invest more than 100% of the portfolio long by using proceeds from the short sales (although not all managers use leverage in this manner, and some fund structures are subject to certain regulatory constraints regarding maximum allowable leverage, as discussed later in this paper).
In addition to shorting, long/short funds have the flexibility to deviate from an equity benchmark in terms of the portfolio’s size and style focus and composition in a way that more benchmark-centric long-only managers may not be able to do. These factors can allow long/short hedge funds to take advantage of the manager’s investment expertise in sector selection. A long/short hedge fund may perform intense sector research and form a thesis on the relative performance of an entire sector. If the fund believes that the given sector should outperform, the manager can significantly overweight the sector relative to a benchmark. Conversely, if the fund formulates a negative view on the sector, it can short the sector, using either individual stocks or a broader ETF to express the view.
Long/short hedge funds can similarly express their views on a specific geographic region. Long/short hedge funds can also use out-of-benchmark securities to attempt to generate alpha on both the long and short sides, in a way that more benchmark-centric long-only managers may not be able to do. Such securities can include stocks in different regions, or of different market capitalization or style, than those in the manager’s benchmark. Empirical evidence suggests that security selection skill on the long side of hedge funds’ trades can add meaningfully to their performance (for further discussion, please see Appendix A). There is less data available to analyze the effect of security selection skill on the short side, but anecdotal evidence suggests that alpha generation capabilities on the short side vary substantially by manager.
Long/Short Equity In A Portfolio – Reason #2: Reduce Equity Beta Risk
Short exposure, when used to balance long exposure, works to reduce market beta—betas on the long side and the short side will partially offset each other. In addition, long/short funds are able to hold cash in their portfolio, with fewer constraints than is the case for more benchmark-centric long-only managers. These two factors help reduce beta and volatility. Often, long/short funds have a modest net long bias (around 30% – 60%); however, as Figure 1 shows, over the past 10 years it has generally varied from a low of around 20% to a high of around 75%. Historically, when equity market volatility has been high, long/short managers decreased their net exposure; when volatility has been subdued, they raised their net exposure back up (see Figure 1).
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