Equity Long/Short

Because life is too short to be just long

DARIUSH ARYEH, THOMAS ALESSIE, MICHAEL GERBER and CEDRIC KOHLER, FUNDANA S.A.

Many investors have been disappointed with their equity allocation lately: poor performance paired with tremendous volatility has left them pondering what to do with their equity risk. Indeed, an old joke from the 1920s is back: “I bought stock for my old age and it worked – in six months, I now feel like an old man!” [1] Should investors exit equities and invest in a bond market which has just had a 30-year rally? Should they
reduce their allocation massively and wait for a rebound to get back in again? Can they get equity-like returns with much less volatility and drawdowns?

We posit that part of the answer lies in using equity long/short managers as a partial replacement for a long-only equity allocation. As we will show in this paper, not only would this substitution enhance investors’ portfolio returns for an overall lower risk, but it would also reduce the impact of bad entry points when entering the equity market and help to avoid behavioural traps whilst maintaining transparency of their investments.

In 1999, two pioneer quantitative equity researchers, Grinold & Khan, were already commenting that “the benefits of long/short investing [versus long-only] can be significant, particularly when the universe of assets is large, the assets’ volatility is low, and the strategy has high active risk” [2].

More recently, in its 2011 survey, the asset management consultant Casey Quirk found that the vast majority of consultants are now thinking of a global equity allocation combining long-only and long/short products together [3]. The same approach is being taken for credit allocations. This leaves other hedge fund strategies, such as global macro and market neutral funds, in a liquid alpha bucket. When decomposed along these lines, the selection of the relevant benchmark is natural: equity indices for equity long/short and cash for liquid alpha strategies.

For the purpose of this analysis, we define equity long/short managers as fundamental bottom-up stock-pickers. They focus on finding large price discrepancies between a stock price and its estimated fair value. These managers can be generalists, or region or sector specialists. We thus do not include equity market-neutral, statistical arbitrage strategies or short sellers.

In order to avoid the biases present in traditional indices such as the HFRI or the CSFB Credit Suisse indices (e.g. survivorship bias, self-reporting bias, non-investible indices), we have prepared this analysis using the track record of a fund of hedge funds which has a pure US long/short equity focus and an 18-year track record as a proxy for an investment in long/short hedge fund managers (hereafter referred to as the “equity long/short proxy”) [4]. We think this FoHF is a good representation of an equity long/short FoHF.

Improving portfolio efficiency
Because equity long/short managers are also active beta managers, Fundana1
they generally capture most of the indices’ upside while limiting the losses on the downside. In turn, this generates an asymmetric return profile. As can be seen in Fig.1, the average positive month for the S&P 500 returns 1.7%. During those same months, the equity long/short proxy is up 0.9% on average. On the downside, the average negative month for the S&P 500 results in a loss of 1.45%, while the equity long/short proxy limits Fundana2losses during the same months to 0.45% on average. In addition, during turbulent months, one can see from Fig.2 (here showing the nine worst months for the S&P 500 since 1993) that the equity long/short proxy is down significantly less than the equity index.

Fig.3 shows the annualized return, volatility and largest drawdown for the S&P 500 and the equity long/short proxy from April 1993 until September 2011.

Fundana3In Fig.4 the performance of the S&P 500 is shown versus the equity long/short proxy. It illustrates well how the above concepts can indeed be implemented. From 2003 until 2007, the equity long/short proxy captured almost all of the upside of the S&P 500, while from 2008 until 2011 it clearly limited the downside. Note that this is not a non-investible
index or a pro-forma track record, but a real track net of fees.

This ability to protect the downside is crucial to generate outperformance in the long run. If over the last 30 years, an investor managed to capture 2/3 of the S&P 500 upside each month while limiting the downside to 1/3, he would have outperformed the index by 100%. Double! Limiting losses makes a significant difference in the long run.

Fundana4
Many investors ask what is the best upside/downside ratio they can hope their managers to achieve? In our experience, capturing 60% of the upside and limiting losses to 40% of the downside on a monthly basis (60/40 ratio) is already very good. Since 1993, this would have resulted in a 40% outperformance versus the S&P 500. However, it is important to consider the frequency with which the investor is evaluating his managers, as this level of outperformance can also be achieved via a 65/35 ratio on quarterly returns or via a 75/25 ratio on annual returns.

By how much can this asymmetric return profile actually improve a long-only portfolio? Fig.5 shows the impact of replacing one-third of an equity allocation with the equity long/short proxy over the same period as above. With just a one-third replacement, the annualized return for the portfolio increases by 28% while the volatility drops by 25%. Note that the largest drawdown is reduced by 21%. It is thus clear that combining a long-only allocation with a long/short component can add significant value by generating higher returns with a lower volatility.

fundana5Poor entry timing costly
Many investors still try to time the market when entering or re-entering equities. This is a hard task and can be costly.

Fig.6 shows the value of $1,000 invested in 1982 in a pure buy and hold strategy compared to the value of $1,000 invested in a strategy which would have missed the 10 best months of the S&P 500 by trying to time the market but that was unlucky. Note that these 10 months represent only 3% of the months since 1982.

The difference in performance is significant. By missing only the top 10 months, you would cut your total return by one-third, so instead of being ahead around $15,000, you would be ahead around $5,000! [5] Is it the same when entering an equity long/short FoHF, an investor may ask? Not really. In fact, since 1993, if you missed the top months in the S&P 500 you would make 45% of the S&P 500’s return [6]. With the FoHF, if you also missed those same ten months, you would be much better off since you would capture 90% of the FoHF’s total return.

Fundana6
Another way to think about the consequences of bad entry timing is to look at how long it can take to recover from drawdowns. Fig. 7 shows the S&P 500 drawdowns as well as the equity long/short proxy’s [7]. This drawdown measure is the value of an index expressed as percentage of its all-time high.

Fundana7a
The dotted lines above show how long it would take to recover from the current drawdowns (as of end September 2011) to get back to the all-time highs, assuming a 5% growth per annum. The difference is staggering: it would take six years for the S&P 500 but only two years for the equity long/short proxy! [8] As Warren Buffet said “Rule No. 1 is: never lose money. Rule No. 2 is: never forget rule number one!”

Making common sense… more common
It is our experience that equity long/short strategies are structurally safer than other hedge fund strategies. The public equity markets benefit simultaneously from an ample liquidity pool, securities that are easily priced (no Level 3 issues) and are subject to regulations (e.g. filing requirements such as 13F, 13D, shorting rules for US managers). The strategy has the additional advantage that investors can understand it more easily. These regulatory filings enable manager selectors to have very good transparency on the hedge fund manager’s positions. As a result, it is much easier to monitor risk factors such as concentration, both at the portfolio level as well as a percentage of company ownership, and to anticipate potential liquidity problems. This is much harder to do for strategies that use mainly OTC markets (such as fixed income arbitrage) or that operate in unregulated environments (for example credit or forex).

It is also important to understand that for investors who are new to investing in hedge funds that the equity long/short strategy is probably the best ground for starting one’s education. As opposed to many other strategies, investors are typically used to investing in equities and to fair stock valuation via fundamental analysis. The major investment differences come from shorting and leverage. While not as simple as they may sound, these techniques are more easily understood than automated trading models, securities or convertible arbitrage done by macro, CTA or relative value strategies.

Emotional roller coaster
Non-professional investors can be subject to large emotional swings when investing. Typically, during bear markets those investors go through phases of denial, fear, desperation, panic and finally capitulation. When the rebound occurs, investors often stay on the side lines because they are so anxious about getting hurt again, thus missing out on big rallies, or worse get in too late. Indeed, Dalbar estimates that over the last 20 years, equity fund investors averaged 3.2% versus 8.2% for a buy and hold strategy for the S&P 5009. Other behavioral economists, such as James Montier, have shown that under stress many investors start focusing on high-risk, high-payoff trades and on the short term [10]. After 18 years of daily interaction and monitoring of long/short managers, we have found that, on average, professional long/short managers are more able to mute their emotions and re-engage in markets faster than other managers.

Doing the same old thing?
Often, market commentators assume that all equity long/short managers do the same thing and thus are very highly correlated. However, our analysis and experience do not support this view. In fact, when looking at the average pair-wise correlation, the equity long/short proxy’s managers are about 40% correlated. Compare this to the stock market correlation. The average stock correlation is currently north of 70%, while the average sector correlation is north of 90%! [11]

The equity long/short proxy’s low correlation is not the resultof coincidence. Indeed, the average percentage of stock overlap between all of its managers is between 3% and 5% [12]. As Sir John Templeton once said, “It is impossible to produce superior performance unless you do something different from the majority”. Again, this suggests that long/short funds can add value to long-only portfolios.

To be ahead of curve think twice
Unfortunately, the equity long/short strategy is also the most populated and represented in the hedge fund universe. Indeed, there are currently 3,710 equity long/short managers according to the Pertrac hedge fund database [13]. The Equity Hedge strategy makes up 27% of the HFRX global hedge fund index, the largest strategy weighting. Should an investor choose one or two managers by himself in order to have a good proxy for the strategy? After all, in long-only strategies managers have similar performances, meaning that if you choose one, you have almost all of the others. Or on the contrary should he have a more diversified allocation?

To answer these questions, it is useful to look at manager return dispersion. This measure gives a sense of how the returns are distributed between the best and the worst managers. If there is not much difference between the returns of the best managers and the returns of the worst ones, then there is little dispersion and there is not much skill needed in selecting one manager over the other. If on the other hand, there is a large dispersion then one needs a great deal of experience and knowledge (i.e. skill) to select the best managers.

FundanaTable
Table 1 shows return estimates for long-only managers (split by market cap focus) versus long/short managers. The dispersion is measured by taking the difference between the top performers (1st quartile) minus the worst performers (4th quartile).

The analysis above confirms that there is more dispersion amongst long/short funds than there is with long-only funds. The dispersion for large cap managers is 10.8%, 11.6% for mid cap and 15.6% for small cap managers. This is much smaller than long/short managers, where the dispersion is 26.9%. Thus, it makes sense to have a team of specialists that can assist investors in sourcing, selecting and monitoring the best equity long/short managers.

Selecting hedge funds requires experience, discipline and in particular a strong network of industry contacts. Whilst the ability to find and invest with hedge funds has undoubtedly become simpler in recent years, the identification of the best managers requires connections throughout the industry which cannot be built overnight. Hedge fund selectors who have been in the sector for a long time and have had the discipline to keep track of analysts and portfolio managers’ career paths can obtain independent opinions about a manager from previous peers or colleagues. This is in stark contrast to recommendations provided by the manager himself which by definition will yield positive appraisals.

In addition, even having identified a strong manager, to keep track of both the investment process (to ensure there is no style drift, for example) and the operations process (to minimize operational risk in the investment) requires significant resources both in terms of time and the expertise of the team.

Conclusions
This analysis has shown how equity long/short managers can improve the resilience of an investor’s portfolio to market losses. In addition, it has shown that not all managers invest in the same stocks or themes, and that the strategy itself is probably structurally safer than many other hedge fund strategies. What would we advise investors to do from here? The first step would be to move their equity long/short managers to their equity bucket. At the very least, the strategy will now have the right benchmark with a long-only index.

If an investor does not already have an allocation to the equity long/short strategy, then we recommend using one as an equity replacement. While the strategy is easy to understand, it is not that simple to implement and thus we suggest starting with a small allocation, use the portfolio transparency to understand return sources and stay with the managers who demonstrate that they have a repeatable process. If the investor team does not have the bandwidth for this additional analysis, then it should consider outsourcing it by selecting an experienced specialized fund of funds manager. After all, even industry veteran Alfred Jones created his own FoHF in the mid 1980s.

To conclude, some investors and market commentators have hastily put all hedge funds strategies in the same bucket, as if hedge funds were an asset class. We believe this is too simplistic and largely the wrong approach. Hedge funds, more often than not, reflect the active management of an asset class, not an asset class in itself. And despite the bad press or some investors’ skepticism, hedge fund strategies like equity long/short do participate on the upside while protecting on the downside as this analysis has shown. As Alfred Jones once quipped, “Hedging is a speculative tool used to conservative ends”.

Dariush Aryeh and Thomas Alessie are co-founders of Fundana and chief investment officer and CEO respectively. Michael Gerber is Partner and Head of Research and Cedric Kohler is Head of Advisory. Fundana S.A. is a Geneva based advisory firm that was founded in 1993. It specialises in advising funds of hedge funds and currently acts as advisor for three funds of funds which have assets under management of $800 million.

1. Laurent Saglio, fund manager of Zadig Fund, a European Long/short Fund
2. “Active Portfolio Management” Grinold & Khan, McGraw Hill 1999.
3. “Old Wine in New Bottles, 2011 Consultant Search Forecast” Casey Quirk, April 2011. A survey of 55 investment consultants – including 15 of the 20 largest North American consultants.
4 . The selected FoHF is Prima Capital Fund, which is advised by Fundana S.A.
5. Various simulations of market timing produce similar results. For example, if the investor mistimed the bottom and missed the two months following each of the 10 worst S&P 500 monthly declines, the outcome would be a return of $11,000 instead of $15,000, still an underperformance of nearly 30% versus a plain buy & hold strategy.
6. We use 1993 as this is the start of the FoHF’s track record.
7. “Equity Hedge Revisited” Ineichen Research and Management, September 2010. See www.ineichen-rm.com for additional analysis on the significance of drawdowns.
8. In fact the equity long/short proxy has outperformed the S&P 500 by 3% net of fees for the last 10 years. Thus using an assumption of 8% as growth rate, the proxy would recover within a year.
9. “2011 Quantitative Analysis of Investor Behavior” Dalbar, March 2011. Available from www.dalbar.com .
10. “Behavorial Investing” James Montier, Wiley Finance 2007.
11. Goldman Sachs Global ECS Research.
12. The percentage stock overlap of Fund A with Fund B is defined as the number of stocks commonly held by A and B divided by the total number of stocks held by Fund A.
13. The actual database source is hedgefund.net