By Michael Weinberg
In 2011 the HFI Equity Index was down 4.39% while the S&P 500 Total Return Index was up 2.1%. In 2012 the HFI Equity Index was up 6.13% and the S&P Total Return Index dramatically outperformed, rising 16%. During the past two years a near consensus industry view has emerged that equity long/short investing is dead. This view was espoused in trade press and in more general financial periodicals as well as at leading industry conferences. On a panel at one of these conferences, an industry veteran went as far as asking why investors were in the strategy at all given the disappointing returns and higher fees vs. long-only.
The rationale as to why returns have been disappointing typically goes something like this: increased competition, record assets in the strategy, and macro-driven markets with high correlation and low dispersion. We agree with most of these points; however we strongly disagree that this means equity long/short is dead, as such a conclusion misses a core, fundamental point about the strategy and the markets.
It is true that we are back to near-record assets in the equity long/short strategy. Peak yearend assets in equity long/short hedge funds according to HFR were $685 billion at the end of 2007. At the end of the most recent quarter, they were $600 billion. Irrefutably, competition for the best trades is a factor. However, though it is difficult to quantify, we believe if one were to add investment bank proprietary trading capital to the two asset levels, industry assets are materially below the record levels likely achieved in the strategy in 2007. As for the markets, in 2011 and 2012 they were highly macro driven. The Euro crisis resulted in extraordinarily high volatility, and large and correlated moves, often on a daily basis. For example, record intraday percentage moves in the S&P 500 occurred with greater frequency in 2011 than in any year since the index began. Correlations were extremely high and dispersion similarly low. Equity markets behaved in a binary manner with risk-on or risk-off, and only more occasionally there was a third state: risk-neutral.
This confluence of events resulted in stocks behaving in a remarkably similar manner irrespective of their fundamentals, which is the worst environment for most equity long/short managers. In simple terms, these managers try to make a spread on longs and shorts. In an extreme example, not too different than last year, when all stocks are moving up (or down) and mostly in similar magnitude, there is no spread for these managers to exploit. Or worse, when stocks are not trading on fundamentals, technical factors can drive down the prices of cheaper companies and drive up the prices of expensive ones, resulting in losses for managers with market neutral books.
So why would one continue to invest in equity long/short? For the simple reason that high correlation and low dispersion represent market imbalances, and a fundamental fact about market imbalances is they eventually balance. In other words, dispersion and correlation are mean reverting. Though neither we nor anyone else can accurately predict exactly when these variables will mean revert, we know it is only a matter of time before they do. Of course the caveat is that like any market imbalances they may persist for long periods. Similarly we have no doubt that at some point this type of inhospitable environment for long/short investors will re-emerge.
Though these periods of imbalanced markets may be unpleasant in the short term for equity long/short managers, the more important point is that they are a necessary evil for the same managers to produce outsized returns over the longer term. Here is a hypothetical example to illustrate why that is. Imagine a zero sum game duopolistic industry where one company is well managed and its competitor poorly managed. Over time the winner will gradually increase its market share, revenues, profitability, cash flow and balance sheet strength; and the loser will experience deterioration in all of these metrics. In an "ordinary" market rational investors notice this and would buy the winner and sell (or short) the loser. These two stocks would likely trade "normally" with a premium valuation ascribed to the winner and a discounted valuation to the loser. For purposes of this example, let us assume that the winner would trade at a deserved 20% premium to the loser based on fundamentals.
In a market environment driven by technical factors, with high correlation and low dispersion, these stocks would trade similarly. Let us assume they both go down by 20% and the disparity in their underlying fundamentals would not be reflected in the price. For an equity long/short manager who had a pair trade on (long the winner, short the loser) there would be zero net returns until the disparity is corrected. However, though no profit is being made, an outsized future return is being created. The short could be covered down 20% at a 20% profit (assuming the sale prices is the cost basis) and the long held on to. When the markets trade once again on fundamentals, assuming the long achieved its prior valuation, the long could be sold up 25% at a 25% gain. This would result in a 45% return on the trade. Opportunities like this are created specifically from imbalanced markets where there is a delay in changed company fundamentals showing up in stock prices.
In general, there will always be companies that are well run and poorly run and overvalued and undervalued. Equity long/short managers are set up specifically to exploit these inefficiencies, whereas benchmark constrained long-only managers have limited flexibility to do so. Thus equity long/short managers have a different source or returns than long-only managers, and for investors looking to diversify their portfolios and limit equity beta, the strategy remains attractive. To maximize value from equity long/short and compound capital at attractive rates of return, investors should select managers that have a consistent repeatable process with strong risk management, enabling them to exploit inefficiencies over a market cycle. Investors will need to acknowledge that for short periods environmental factors may preclude profitability, but should also understand that these periods of imbalance have an important role in generating future returns. This is why we are comfortable that equity long/short investing is not dead and never will be.
Michael Weinberg is an adjunct associate professor of finance and economics at Columbia Business School. He was formerly in charge of equity and event allocations at multistrategy fund of hedge funds firm FRM where he served on the investment and management committees.