By Nick Evans
There is still a quarter of this exceptionally turbulent and
uncertain year left to go, and much could yet change for better
or worse, but 2011 has clearly not been a vintage year for
long/short equity - most of all in Europe.
For several individual funds, it has been borderline
disastrous - with some down as much as, or even more than, the
markets themselves after a thoroughly rotten third quarter.
For a notable few, it has provided the chance to shine in
the toughest of circumstances - and those who have prospered
through the chaotic markets of July, August and September
should be amply rewarded by investor inflows.
But for the vast majority, it has been a hard and
unrewarding slog - with stock-picking, both long and short,
proving almost impossible at a time when equity markets are in
the grip of whipsawing macro sentiment and when fundamental
valuations appear to count for little.
Overall, the correlation with equity markets is ticking up -
which is the last thing that investors want to see. And the
universe of funds that can truly point to consistent success at
uncorrelated returns, capital preservation and alpha generation
So is long/short equity somehow 'broken'? Could it be the
case - in such a febrile risk-on/risk-off market where
conviction is dangerous, where leverage is reduced, where
short-selling bans curb flexibility, where the macro mood is
prone to sudden and savage swings, where investors want the
upside but not the downside, and where the penalty for being
wrong is far higher than the reward for being right - that
long/short equity just doesn't work?
That would be an overly generalised and simplistic
conclusion. Overall, the EuroHedge long/short European equity
index is down by some 5% this year - against markets that have
fallen by some 12%, and which were down by some 20% in the
third quarter alone.
That does represent a creditable degree of downside risk
protection and relative outperformance - underlining that
managers are, in aggregate, doing their job for investors whose
long-only portfolios are doing far worse.
Of course, hedge funds were not supposed to be about
relative returns. Indeed it was a desire to get away from a
long-only culture where losing less than the market was deemed
to be acceptable that drove so many managers into long/short
investing in the first place.
But human nature being what it is, relativity is never far
away - and it is that relative outperformance, which so many
managers scoffed at in earlier and perhaps easier times, that
may now prove to be their saviour and chief selling point.
Over a longer timeframe, the relative outperformance
argument stands up even more powerfully - and there cannot be
many investors left who are not painfully aware that if they
had invested substantially more of their money in long/short
equity rather than long-only over the past 10 years, they would
have substantially more of it now than they do.
For institutional investors charged with funding long-term
liabilities, that is a very compelling argument - and one that
can no longer be ignored. But it holds true for every kind of
investor. By dampening volatility, mitigating tail risk and
avoiding the large capital losses that kill compound returns,
long/short equity does truly add value.
So, far from abandoning long/short equity, many investors
are now questioning if now is the time to put all of their
equity portfolios into long/short and to end the nonsensical
split between long-only equity and hedge funds (as if hedge
funds were somehow a separate asset class, rather than a style
of managing money).
Of course there are investors in funds down 20% or more this
year who are questioning the value proposition of long/short
equity. But distinctions will be drawn between those that can
show good performance over time and can clearly explain their
drawdowns - who will probably be given another chance - and
those that can't, who almost certainly won't.
There will doubtless be some heavy recycling of assets
between funds that have coped well with this torrid time and
those that haven't. For long/short equity as a whole, market
correlations cannot afford to rise too much further without
serious questions being asked over the fees compared with the
long-only world. And it is questionable whether 2 and 20 is
really the price that investors are prepared to pay for
long/short equity these days anyway.
But long/short equity is not dead. On the contrary, what
appears to be a very bad and worrying year may actually turn
out to be the start of a major change in investor attitudes in
favour of, rather than against, the long/short model - but the
price may need to change.