Is long/short equity ‘broken’?

Fri Oct 21, 2011

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Stock-picking, both long and short, is proving almost impossible at a time when equity markets are in the grip of whipsawing macro sentiment

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 is shrinking.

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.