By Nick Evans
has been exceptionally turbulent and uncertain, clearly not a
vintage year for long-short equity - especially not in
For several individual hedge 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 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 very 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 point to truly consistent success at
uncorrelated returns, capital preservation and outperformance
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, 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 generalized and simplistic
conclusion. Overall, the EuroHedge long-short European equity
index was down by some 5 percent through the third quarter,
against markets that had fallen by some 12 percent over the
same period (and which were down by some 20 percent 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
Of course, hedge funds were not supposed to be about
relative returns. 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 savior and chief selling point.
Over a longer time frame, 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 much more of their money in long-short equity
funds rather than long-only funds over the past ten 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 funds, many
investors are now questioning if now is the time to put all of
their equity investments into long-short funds 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 percent 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 much further without serious questions being
asked about the fees compared with the long-only world. And it
is questionable whether 2 and 20 is really the price investors
are prepared to pay for long-short equity these days
But the strategy 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 favor of,
rather than against, the long-short model. But the price may
need to change. AR
Nick Evans is editor of EuroHedge, a publication of
HedgeFund Intelligence. A version of this column first appeared
in that newsletter's October 2011 edition.