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Long Short Equity: Beneath the Surface

12/19/2017

Are you considering an allocation to Long Short Equity Funds in 2018 like many Advisors we speak with? If so, you may find value in this blog where we aim to peel back the layers of the Long Short Equity category to help Advisors gain a better understanding of the different roles that strategies play and how they fit into an overall Asset Allocation portfolio. After several years of net outflows from the category, investor attention has returned in recent months.

Morningstar® estimates that Net Flows into Long Short Equity Mutual Funds began to accelerate this summer, after three years of net outflows from the Category. Many Advisory Firms have begun to re-implement a more cautious posture entering 2018 after outsized broad equity market returns over the last 9 years.
 

However, not all Long-Short Equity Funds are the same, so we thought it would be beneficial to break down the category and offer some of our own insights into the various roles that Long-Short strategies play within client portfolios to assist in your due diligence process. It is important to note, that Long-Short Equity is inherently an Active investment strategy; Passive vehicles are not an option.

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There are only 80 Funds in the Category (excluding duplicate share classes and non-US Funds) with Total Net Assets of $33.7 Billion. Assets are fairly concentrated with the Top 5 Funds controlling two-thirds of all the Net Assets. 3 of the Top 5 Funds are closed to new investors (Boston Partners, AQR, Diamond Hill), and 1 of them is a Multi-Manager Fund (Columbia) that is sub-advised by 2 of the Top 5 Funds (Boston, AQR). Advisors may need to dig deeper, since the Name Brand Funds are effectively “sold out”.

Long Short Equity 101

There are 3 broad styles of Long-Short investing within Mutual Funds that we have observed. 

  1. Hedged Long Equity – Typically 75-100% net long, with some type of dynamic hedging mechanism. These strategies typically have greater Up Capture in rising markets, but may not offer Downside Protection in falling markets and may not have a true short portfolio of individual stocks.
  2. Traditional Long Short - Typically 50-75% net long, with a true short portfolio of individual stocks, along with hedging strategies. This approach attempts to generate returns from both Long and Short portfolios independently, which may generate positive absolute returns in falling or sideways markets. They may also lag the broad indices in rising markets.
  3. Low Net Exposure – Typically very Low Net Exposures (less than 50%). These strategies may have lower Up Capture in rising markets, but may offer significant Downside Protection in falling markets.

Market Cap and Stock Style Considerations

Just as Advisors allocate capital within traditional Long Only categories, the same approach applies to Long-Short Equity, and should be a strong consideration when evaluating and selecting managers. 

  1. Large, Mid and Small Cap constitute approximately 35%/45%/20% of the average market capitalization of strategies in the Category respectively. Size Factors often contribute to relative performance within the group, and should be considered for optimal diversification.
  2. Value, Core and Growth Styles are also well represented within the Category. Additionally, Funds that are generally Long Value tend to be Short Growth, and vice versa, which may also contribute to relative performance dispersion, especially in recent years.

Long Portfolios Drive Returns

Most of the time, the Long Portfolio of most Long-Short Funds will be the greatest contributor/detractor to returns in the period and should be evaluated in the same manner as a Long Only manager. This can be a key factor in performance evaluation and style/cap overlap with other Long Only holdings.

Short Portfolios Drive Alpha

Although not as frequent, the Short Portfolio of a Traditional Long-Short Fund may generate significant Alpha. This often occurs in falling or sideways markets such as 2000-2002, 2005, 2007-2008, 2011, and 2015.

Recent Returns and Morningstar® Ratings

Since Morningstar does not distinguish market cap and styles within the Long-Short Equity Category, the rating systems is inherently flawed by these differences among the peer group as evidenced by the large dispersion in 3 and 5-year annualized returns. With only a few exceptions, the current highest rated funds are generally Growth funds and the lowest rated funds are generally Value.

More Than Meets the Eye

Many Long-Short Funds are newer and have shorter track records as Mutual Funds, however many of these Funds also have longer track records as Separately Managed Accounts and/or Hedge Fund formats. This data is typically only available upon request.

Constructing a Long Short Equity Allocation 

Due to the factors discussed previously, the standard deviation of calendar year returns within the Category is extremely high, averaging 750 basis points over the last 7 years and twice as high during the last bear market. As a result, it is prudent for Advisors to take a thoughtful approach in building out a Long-Short Equity allocation that incorporates the number of variables discussed.

Source: Morningstar Direct as of 12/18/17.  

If you would like to learn more about Goodwood, view our investor presentation or read our quarterly commentary. 

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ABOUT THE AUTHOR

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Jonathan Bale: Goodwood Capital Management.

Jonathan joined Goodwood in December, 2013. Prior to joining Goodwood, Jonathan worked at FPL Asset Management (2013). Prior to FPL Asset Management, Jonathan played golf internationally for the Golf Union of Wales. As a representative of his native country’s National Team Jonathan competed in over 100 World Ranking events across Europe and the United States, regularly participating in clinics, outings, and Pro-Ams benefiting various charities and non-profit organizations.

To read Jonathan Bale's full bio or other Goodwood team members, click here

 

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