Implemented successfully, a long/short equity strategy can help investors profit from rising share prices from its long positions, and profit from price declines below the index from its short positions, Damien McIntyre explains.
The concentrated nature of the Australian share market — with the top 20 stocks comprising nearly 60 per cent of the market capitalisation of the S&P/ASX 200 Index — means it can be hard for an active, long only manager, to achieve its benchmark outperformance goals.
Enter the long/short active extension equity strategy.
An active long/short equity strategy aims to benefit from both rising and falling markets. It works like this: if a fund manager believes a company's share price will appreciate, it will buy and hold shares in that company, or "go long".
Conversely, if the manager believes a company is overpriced or will be affected by structural, economic or company-specific issues, the manager can "go short" and sell its shares.
The strategy addresses one of the great limitations for long only active investors in the Australian equity market: the constraint that comes from a very concentrated benchmark.
There are a number of companies at the top end of the Australian market that weigh heavily on the index.
A long only investor is limited to what stocks they can long, but are also limited on the stocks they can underweight, because they are limited by the index.
Many of the active returns we see from fund managers in the Australian market come from taking an overweight or underweight position in selected stocks.
Having a long/short structure allows the fund manager to short those stocks that the manager believes are going to underperform the benchmark, and to then reinvest in companies that have better prospects.
The strategy provides the opportunity to unlock returns that are not available to long only investors.
At the same time, this is a strategy that provides for greater diversification across the entire investment portfolio.
An investor's greatest tool in achieving a good risk/reward tradeoff is diversification.
Traditional active managers are forced to take benchmark relative positions (i.e. either underweight or overweight) and tend to focus on those stocks that can most impact returns — i.e. those that have the greatest weight in the index.
Although a long only fund may be benchmarked against the S&P/ASX 200 Index, it is common to see the top 20 or 50 stocks dominate these portfolios.
While a long/short active extension strategy is still relative to the benchmark, it has greater potential to diversify compared to traditional long only strategies.
The combination of long and short positions can add to the diversification in a portfolio.
The long/short manager is more likely to consider the lesser weighted stocks for long or short investment, the objective being to seek positive returns from either transaction.
What's more, if an investment manager can have a larger number of stock decisions in a portfolio, and a broad investment process feeding into that, this can help to mitigate risk, particularly in a volatile market.
The long/short advantage
Long/short active extension equity strategies are less constrained — in other words, not beholden to an index.
Because of this, long/short strategies have the advantage over long only strategies such as traditional equity funds and equity exchange traded funds (ETFs).
Short selling myths
A lot of people are hesitant when thinking about shorting, and believe that it is some sort of a vulture approach to destroying company value.
But another way to look at it is as a vibrant part of the economy and the market.
There will always be new capital, along with new ideas and new companies and sectors rising to ascendency.
Over the medium-to-long term, a successful fund manager can add value for investors by identifying those up and coming companies.
The other side of this coin is that there will always be companies in their twilight that are experiencing tougher times.
They may have lost their competitive advantage, they may be experiencing more competition, capital may have eroded their pricing power, or economic conditions might not be supportive.
By looking only for the winners in the market, an investor is only getting half of the investment picture.
Most of the investment attention is focused on the winners. But having a focus and a process that looks at the other side of the coin — those companies that are going into decline and going to be underperformers — allows a fund manager to unlock an area that has not been as picked over as closely as others in the markets.
And that is where the opportunity lies for the short investor.
Risk and return
The main risk associated with long/short investing is that it amplifies the investor's exposure to a fund manager's investment skill.
If the manager selects stocks poorly, the outcome could be worse than it might be for a long only fund.
There is some additional risk in short selling. If the borrowed stock is recalled, it may force a repurchase of the stock at the same time.
Long/short investment strategies can complement a core holding of a cheap market index option, by providing the opportunity for alpha at the edges of the investor's portfolio.
It is often considered to be an appropriate strategy for those who are younger and firmly in the accumulation phase of their investment life.
Recognising that time is on their side, they can take on the added risk that comes with equity exposures and growth assets.
A good active manager that can generate returns above the index over time will make a significant difference in boosting the superannuation balances of younger investors, and over the long term — with the magic of compounding — show a marked appreciation in the value of their assets.
However, there is also an opportunity for people who are older, and even moving to the retirement phase, to look at long/short fund managers for some of their retirement savings.
Longevity risk is a real concern for these investors. Life expectancy keeps extending and one of the greatest risks is that people will start to run out of money before they run out of life.
Increasingly, investors are realising that opting for a completely conservative investment allocation is not a viable solution.
They recognise that there should be some allocation towards growth assets, and a long/short Australian equity fund may meet that criteria.
There is no getting away from the fact that a long/short fund is at the upper end of active managers in terms of risk and the active risk taken relative to the benchmark.
However, this strategy offers the potential to achieve higher levels of return compared to the benchmark than those funds that focus on long only positions.
As well, the incremental risk/return trade off can be more attractive than that on offer from long only funds.
Nevertheless, this option is not for those investors who will be worrying about where the fund is on a day-to-day basis, as it may experience more short-term volatility.
However, for investors that can be patient over a period of years, this volatility tends to wash out over time.
The ideal time horizon for any equity fund is a three-to-five year minimum — and potentially even longer.
This is a high growth /high volatility asset class. It is very liquid, but equity markets and even individual active funds can move around a lot over time.
And very short periods of returns — particularly over one or two years — are not necessarily indicative of what the fund or the market will deliver over a longer period.
When traditional funds that take long-only positions construct their portfolio, the benchmark chosen (for instance, the S&P/ASX 200 Accumulation Index) generally determines the size of the fund's stock positions, and therefore its performance.
A long/short fund, however, has a larger set of investment opportunities. It can take short positions by borrowing shares from other holders and selling on-market. By then reinvesting the proceeds in long positions, it is well-positioned to generate returns above the benchmark.
Put another way, a long/short fund is not just focused on the good news stories but can also take advantage of negative views of stocks and sectors, as well as weaker fundamentals.
Damien McIntyre is the director and head of distribution at Grant Samuel Funds Management.