The case for long/short equity funds as volatility rises

Long/short, or hedged, equity approaches can offer investors the opportunity to lessen the price volatility of a diversified stock portfolio while still participating in rising markets. Historically a hedge fund strategy, long/short equity has become an increasingly popular choice for mutual fund investors seeking the potential downside protection that most long-only equity funds can’t provide. Long/short strategies also provide some upside participation in rising markets.

Long/short funds are one of the most popular strategies among so-called alternative investments, which are designed to provide diversification because they don’t move in lockstep with stocks and bonds. 

As the name suggests, these funds hold stocks through long positions, and they also short stocks on which they have a negative view. Investors who short stocks borrow them, sell them to other investors, and then seek to buy them back at a lower price, profiting on the difference. Essentially, shorting stocks is a way to profit from declining share prices. It should be noted that some long/short funds may invest in entire sectors through exchange-traded funds (ETFs), rather than individual stocks.

Essentially, long/short funds take long positions in stocks they see as attractively valued and expect to go up over time, while shorting areas of the market they view as overvalued and expect to decline. That means these funds can participate in rising markets while also helping to limit the impact of market declines. 

To be fair, long/short funds haven’t been on many investors’ radar screens since stocks have been in a bull market for several years. That’s because they tend not to keep pace with long-only strategies in strong bull markets. However, the historic sell-off in 2020 due to the economic impact of the COVID-19 pandemic has some investors looking for ways to limit volatility and diversify their equity positions.

Indeed, the past several months have been a roller-coaster ride for stock investors, with the magnitude and number of one-day market moves hitting levels not seen since the 1920s; for example, the number of daily moves of at least 1% in the S&P 500 Index has spiked recently.

Even though markets have rallied back sharply after the initial decline earlier in 2020, the uncertainty is likely to persist as we learn more about the virus and its potential long-term impact on the economy and society. The ability of long/short managers to dial up and down net exposure during times of uncertainty may appeal to some investors.

Due to the elevated volatility and uncertainty investors are facing now, long/short strategies could be a way to maintain equity market exposure with some downside protection. For example, in 2008, funds in the long/short equity category fell an average of 15.4%, versus a 37.0% decline for the S&P 500 Index.¹

Looking at more recent episodes of volatility, Morningstar’s U.S. long/short equity fund category fell 8.6% in the fourth quarter of 2018, compared with a loss of 13.5% for the S&P 500 Index. And in the first quarter of 2020, the category lost 12.8%, versus a 19.6% decline for the S&P 500 Index.² This speaks to the ability of long/short funds to potentially dampen volatility.

Also, more investors are looking at alternative strategies like long/short equity because cash and bond yields are so low due to central banks responding to the pandemic with monetary stimulus measures.

Finally, long/short strategies typically give investors a chance to participate in rising markets. For example, Morningstar’s U.S. long/short equity fund category gained 11.2% in 2017, a year that saw the S&P 500 Index rise 21.8%. In 2019, the category rose 11.9%, while the S&P 500 Index climbed 31.5%.³

It’s important to remember there are several specific approaches that fall under the broader long/short equity category. However, it’s fair to say that most long/short equity strategies attempt to generate alpha (incremental return over a benchmark index) in three ways.

First, like any equity fund, it can add value through the selection of long stock positions. Second, it can tactically hedge its net market exposure, or beta, when conditions warrant by using derivatives or by shorting baskets of stocks or ETFs.

Third, a long/short fund can potentially add alpha by choosing which ETFs or other equity assets to sell short if the manager expects those particular instruments to decline in value. The key to success in all cases is nimbleness: The best long/short managers have the ability to dial net exposure up or down while also populating the fund with fertile investment ideas on both the long and short sides.

Long/short equity strategies are in focus due to 2020’s sharp sell-off and rising volatility, which is a change in tone from steadily rising markets.

Another factor that may create opportunity for long/short managers is the recent dispersion of sector performance; in other words, the economic impact of the pandemic is creating winners and losers among different sectors.

In an upcoming viewpoint post, we’ll focus more on how long/short equity managers can add value by thoughtful positioning in sectors using fundamental research. 

1 “The Long and Short on Long-Short Equity Funds,” Morningstar.com, June 2018. 2 Morningstar Direct, as of March 2020. 3 Morningstar, as of December 2019.