Unsteady market fuels flight to long/short funds

1 May 2020

The voracity of COVID-19 has unequivocally spread into every corner and pocket of the globe, with the speed of the infection causing ongoing and widespread global consumer panic. The comparison with SARS in 2003 is now even less relevant as SARS was much more regionalised despite the higher mortality rate. 
 
Investors’ initial apathy towards COVID-19 was astounding, as in the space of three weeks, the Australian Securities Exchange (ASX) and global equity markets collapsed – plummeting from all-time highs to entering into a bear market – with more than 20% wiped out. The correction has since been cited as one of the fastest drops in the local equity market since 1987. 
 
The speed and the severity of the current equity market correction however will have ramifications for many companies, particularly those with higher leverage and discretionary revenue sources. Yet even further weakness is still to be exposed, namely in the travel sector, and particularly for those with high operating leverage, and with consumers practically hiding in bunkers, the downgrade will be much more broad-based.
 
The crash that was March, 2020 happened so swiftly and decisively that many investors remain in a state of shock, and given the protracted nature of uncertainty, it’s likely that over the next six to 12 months more attention will be paid to long/short managers. 
 
And for good reason. 
 
The philosophy of long/short managers serves them well in market conditions currently being experienced – not only are they positioned for falling markets, but also rising markets at the same time. Over a 10 to 15-year period, long/short managers are consistently in the top-performing quartile, largely due to their ability to manage risk more effectively. 
 
Utilising tools such as long stocks and shorting companies means a manager will borrow a stock and then short sell them; the combination benefitting from both directions of the market while staving off many of the inherent risks associated with trading equities. 
 
Long/short equity strategies are less constrained than some others, and are 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). 
 

Market drawdowns and gains needed to recoup losses

 
With the recent market volatility, the advantage of having the ability to short in a fund is clear. With the market falling 20% to 30% during a single month, shorting helps a long/short manager take advantage of cheaper prices without taking on an excessive amount of risk.
 
Often when an investor is researching whether or not to buy a stock, the fundamentals of the decision making are straight-forward – company management and governance, performance, dividend history, price to earnings ratio etc. The focus is on whether the stock will rise in value. But, with the flexibility of shorting, should the share price fall, an investor can still generate a return so long as the funding stock has fallen more.

SECTOR SENSITIVITIES

In a portfolio construction sense, for sectors that are susceptible to high volatility, a long/short strategy can work especially well. The technology sector is a good example. It’s a sector that delivers high growth for investors, but is also highly expensive and very volatile (with movements of 5% to 10% in a day not uncommon). Many long-only managers find it difficult to invest in this sector because they are unable to manage the volatility. In this case, a long/short manager would take advantage of the ability to short to neutralise sector exposure while still buying quality growth companies.
 
Resources would be another sector where investors could pick up large, diversified names on the back of sharp price corrections as forward cashflow projections remain strong, and they will be the first to move when the recovery does arrive, while at the same time taking out risks by shorting lower-quality mining businesses that would struggle with cashflow as commodity prices fall.
 
There are also sectors where there will be strong price mean reversion, such as property trusts, for example. Long/short managers are able to play the spread without adding additional risks nor capital to the portfolio. 
 
Most sectors, however, work well using a long/short strategy as, at any time, most will have companies trading at extremes valuations, or mispriced earnings. 
 
RISK AND RETURN
 
Shorting has been a controversial topic in Australia and has often been unfairly blamed for creating excessive volatility in markets. However, short selling doesn’t change the underlying fundamentals of a business; in fact, it creates opportunities for investors with differing views, aids in price discovery and provides greater market depth.
 
The main risk associated with long/short investing is 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. This is quite a rare occurrence, but can happen. Risk can be managed by ensuring that short positions are primarily held in liquid securities rather than the small, low liquidity assets whose price will move further in the event of a short squeeze.
 
SUITABLE INVESTORS 
 
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 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 and return trade-off can be more attractive than those on offer from long-only funds.
 
Nevertheless, this option isn’t 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 several 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 – aren’t necessarily indicative of what the fund or the market will deliver over a longer period. 
 
In summary, investment portfolios should in many respects be chartered with caution at the current time but, having said that, market conditions are ripe for active management. A portfolio that has the opportunity to thrive in all market conditions and that has the flexibility to take advantage of price volatilities is a sound strategy to pursue.
 
Long/short equity strategies offer an investment style that takes advantage of the precarious nature of the equity market because the equity market is such an emotional instrument, moving from greed to fear, the mispricing opportunities are many and varied.
 
The equity market rarely prices a stock accurately – it’s always too much or too little, and as a long/short manager, you can consistently capture that mispricing. It’s a complete instrument in generating an equity return that can capture equity market exuberance.  
 
Jun-Bei Liu is lead portfolio manager at Tribeca Investment Partners.



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