Equity long/short as a core allocation

Weaker prospective returns, rising volatility, and persistently high correlations across asset classes are three market forces likely to shape investment management in the years ahead.

Given today's high stock valuations and low bond yields, conventional portfolio construction practices may not generate the same generous results that the average investor has realized in recent decades. Longer life expectancies and the diminishing presence of defined benefit pension plans introduce additional complications, as retirees face the growing risk of outlasting their assets. Fortunately, financial professionals and investors now have a greater range of tools to draw on when confronting these challenges—equity long/short mutual funds offer a case in point.

For those investors employing a risk-budgeting framework, lowering the price volatility of the portfolio's equity exposure allows for a higher overall allocation to the equity asset class. Endowments and other institutions have embraced this notion by allocating to hedge funds for years, and the idea has become increasingly important to individual investors and their financial professionals since the 2008 global financial crisis as more equity long/short strategies have migrated from the hedge fund world to the mutual fund universe. Equity long/short mutual fund assets grew more than tenfold from 2008 to 2015, as net inflows to the category totaled $30 billion; by contrast, active long-only U.S. equity mutual funds saw nearly $660 billion in net outflows during that period.¹

Reducing the probability of extreme portfolio losses is especially critical for newly retired investors balancing spending goals with longevity goals since the sequence of realized returns becomes a more crucial consideration as their portfolios transition from the accumulation to the distribution phase; all else being equal, loss recovery times are much longer for portfolios with net outflows than those with net inflows. Yet a wholesale shift to fixed income may not be the best way to decrease risk in a low interest-rate environment. For these reasons, equity long/short strategies are likely to become a more integral part of the average investor's mainstream equity allocation and less of an esoteric outlier in the future.

In an attempt to glean more insight about the implications of holding equity long/short strategies over different market regimes, we analyzed rolling one-year returns from 2000 to 2015. We found that, as rolling broad market returns decreased, so did the historical performance advantage of unhedged equities over long/short strategies. Further, we noted that in choppy or flat market periods, equity long/short managers don't necessarily need a sustained market rise in order to post positive total returns if they can capture a favorable spread between the relative performance of their long positions and their short positions. Over time horizons spanning at least a full market cycle, long/short strategies have fared well, both in absolute terms and relative to unhedged equities: For the 2000 to 2015 period, as a whole, the HFRI Equity Hedge Index generated annualized returns of 4.8%, with a standard deviation of 8.5%, while the S&P 500 Index generated lower annualized returns  of 4.1%, with a higher standard deviation of 15.1%.²

An allocation to equity long/short can be characterized as an equity and as an alternative asset class. Since equity long/short managers invest in equity securities and have the added flexibility to take short positions in assets they believe will underperform, the result is often a portfolio that's highly correlated with stocks, but one that experiences relatively muted price volatility across the investment cycle. The short positions tend to constrain a portfolio's upside potential in steadily rising markets, but the shorts also offer the potential of better downside protection during falling markets. Moreover, markets can experience prolonged states of choppy price movements where the broader trend is essentially sideways; during these violently flat periods, equity long/short managers may have a distinct advantage over their long-only counterparts. The ability of long/short managers to dampen price volatility through shorting has led many institutional investors to treat long/short strategies as a complementary, defensive form of equity exposure to be integrated with unhedged equities as part of the portfolio's overall structural stock allocation. Now, thanks to the rise of equity long/short strategies within the mutual fund marketplace, individual investors have a greater opportunity to do the same.

1 Strategic Insight, 2016. 2 Morningstar, Hedge Fund Research, 2016.