Long/short equity. Into the core?
Changing demographics and low productivity growth, combined with elevated equity valuations, tight credit spreads and low interest rates, make for a challenging environment for investors’ ‘core’ portfolio going forward. Whereas it is still helpful to introduce ‘satellites’ of diversifying assets, such as commodities, real estate or hedge funds, it is no longer enough. The ‘core’ as we know it, is broken.
Fixing the ‘core’
To improve the ‘core’, we propose the introduction of long/short equity directly into it. Whereas genuine ‘satellites’ deliver real diversification benefits through their very low correlation with the ‘core’, equity long/short strategies have high correlation with it, since the equity risk premium is an inherent source of their return. High correlation is actually a benefit, as it offers a degree of return predictability that is an important characteristic of a ‘core’ allocation. The main risk-mitigation benefit, from adding long/short equity, consists in the reduction of the ‘volatility drag’ on the compounding of returns, by lowering the downside capture of the ‘core’ portfolio. That is, the short equity component can play the role that in the past was bonds’, as shown by the HFRI Equity Hedge index, that has historically resulted in a downside risk similar to a 50/50 balanced portfolio’s.
Given their current low expected return and higher risk, consequence of the present low interest rates environment, bonds may not fulfil their risk-mitigation role as well anymore. Whereas bonds provide risk mitigation only when interest rates fall, equities’ short side provides risk mitigation for declining equity prices, regardless of the reason behind the decline. Therefore, the combination of bonds and equity shorts provides a more diversified risk mitigation strategy than bonds alone.
But what about the upside? Equity long/short generated stellar returns relative to the balanced portfolio during the 1990s but struggled during the recent period of massive monetary stimulus. However, with the world’s central banks normalizing monetary policies, long/short may shine once again.
For our purpose, however, whether it is the traditional ‘core’ portfolio or the equity/long short that will generate the highest return going forward is of secondary importance (besides being unknowable). What matters is that the strategies have a sufficiently similar payoff, so that allocating to both provides a robust diversification leading to higher ‘terminal wealth’.
It is worth pointing out, nevertheless, that the current market environment – high equity valuations and low interest rates – favours the equity shorts over holding bonds. To begin with, rising interest rates would be negative for bonds, yet they would be positive for equity shorts especially at this point in time, when an estimated duration of 30-40 years should make equities particularly sensitive to interest rates. Furthermore, low interest rates and high equity valuations mean that the negative carry from being short the equity risk premium is most likely going to be lower than normal, whereas the positive carry from bonds is lower than normal. Hence, the present relative attractiveness of short equities versus bonds as a risk mitigator.
Value creation from the long/short strategy
The long/short strategy aims to create excess return along three dimensions: the long book, the short book and the adaptation of the portfolio’s gross and net exposures to equity risk.
In the long book there are two potential sources of excess return. One is the traditional ‘alpha’ of long-only portfolios, the result of pure stock-picking. The second source of return is the asymmetric upside/downside capture of the market performance. Whereas there are multiple approaches to achieve this, a recent popular approach was to invest in names that are low in volatility and high in quality. The asymmetric return profile of low volatility investing limits the drawdowns of the long book, thus maximising the compounding of returns over time.
As for the short book, we can identify three potential sources of excess return. The first one is the inverse of the long book’s high-quality, low-volatility investing, that is to say selling short high-volatility stocks that are expected to display a higher downside than upside capture. The second potential source of return is generating ‘alpha’ from traditional stock- picking. Often, good short ideas only carry small weights in the various benchmarks, thus simply underweighting them in the long book does not offer much ‘bang for the buck’. The possibility of shorting them, instead, can make a significant impact on performance. Here, we also benefit from an ‘efficiency gain’, as the knowledge generated by the ideas for the long book can be ‘reused’ to pick suitable shorts.
The third source of value added is what we could call ‘shorts’ dynamic allocation’. Being chronically short the equity premium entails a high opportunity cost, and there are times when the set for shorting opportunities is simply too poor. In other words, as mentioned above, there are times when it’s better to be short than others, and times when it’s better not to be short, at all. Therefore, the ability to pick shorts only from favourable opportunity sets, and staying away when there aren’t any is, in our opinion, what really discriminates success from failure on the short side. Importantly, here we are not talking about top-down market- timing, rather a profound understanding of how the shorting opportunity set changes through time, regions and industries. Selling short into themes flush with liquidity or into strengthening industry dynamics is a dangerous ‘swim against the tide’. When most stocks belonging to a ‘hot’ group go up, the probability of identifying one that will go down is simply too small.
The chart below provides an illustration. Here, we look at ‘wealth destructors’ in the Consumer Discretionary sector, that is firms that generate return on capital below their cost of capital. We define ‘Spring’ as the point in the cycle when investors’ risk appetite is low and central banks are stepping on the gas. ‘Fall’ is when risk appetite is high and central banks are stepping on the brake. Note that during Spring, ‘wealth destructors’ experience 65% positive months with an average return of 9%, and 35% negative months losing on average 4%. It is simply too hard to pick shorts when the opportunity set is so meagre. On the contrary, during Fall, the group only sports 45% positive months with an average return of 4.5% and 55% negative months losing 6% on average. Whereas it is not trivial to find good shorts in the Fall environment either, it does at least offer the manager an opportunity to gain an edge.
Finally, the long/short manager can add value by varying the amount of ‘dry powder’ (cash) held to capitalize on tomorrow’s opportunities, or by tactically employing market hedges. The competent reinvestment, into equity risk, of the cash and proceeds from hedges is an often under-appreciated source of excess return of long/short strategies: if left uninvested, cash foregoes the equity premium, thus locking-in low returns.
Summary of the advantages of including equity/long short in the ‘core’
We believe the benefits of long/short strategies may be greater today than it has been the case in decades: the current low interest rates, high equity valuations, poor demographics and increased political uncertainty all combine to increase the need for risk mitigation.
Long/short equity can be expected to: Limit portfolio drawdowns, which in turn:
Reduces the ‘drag’ on returns’ positive compounding. Positive compounding of returns is necessary to build wealth over time, yet cruel mathematics governs equity returns: a 50% drawdown requires a rebound of 100% just to get back up to break-even. Which explains why it is critical to limit portfolio’s drawdowns, to allow positive compounding to work its magic.
Helps investors to hold-on to their positions in challenging markets, rather than selling at the wrong time. According to a long-running study by DALBAR, investors earn less than half the return generated by the funds they invest in, as they flee the market during unruly times only to buy it back at higher levels.
Offers investors more flexibility in budgeting portfolio risk and the opportunity to increase the allocation to return-seeking strategies. A properly risk-managed equity allocation allows for an increased exposure to higher-risk equities, such as small caps or emerging markets, or to increase the overall equity allocation versus bonds.
Diversify bonds’ role as the portfolio’s risk mitigator. Thirty-seven years of a bull market in bonds, interest rates at their lowest levels in 5,000 years, an enormous mountain of global debt: in such an environment, it is unlikely that bonds will be as effective a risk mitigator in the future the way they have been for decades. Hence the value of long/short equities as a diversifying mitigator