The Future of Long-Short Equity
Pundits have had a field day proclaiming that the days of long/short equity meeting the needs of investors are over. Measured against the market, long/short equity strategies have indeed had a worse five-year run than in the past.
Although historically one of the leading strategies in the hedge fund world, long/short equity has also underperformed other venues for hedge fund investment recently.
The harder question to answer is, what will the future hold?
The behavioral tendency for investors to extrapolate recent returns into the future and act accordingly isn’t merely a Pavlovian response to viewing performance statistics; it often goes hand in hand with a rational story that predicts what will happen by explaining what just has happened.
In this case, some of the variables in the equation that determine long/short equity returns have been under pressure. Since the 2007–09 financial crisis, long/short equity managers have had to contend with low interest rates (which reduce returns on cash balances), high borrowing costs (which further erode short rebates), stock price volatility (which confounds portfolio construction), and high correlation with low dispersion (which causes risk-on/risk-off behavior to dominate fundamental analysis). Although past conditions may not be indicative of future ones, many people point to this environment when explaining why long/short equity will suffer for some time.
To be fair, I can’t think of a sound argument why these structural challenges will abate anytime soon. In all of my investment reading, I have not seen a single compelling case for a near-term rise in short-term interest rates, reduction in borrowing costs, or calming of market volatility and correlation (although both have happened). Furthermore, much more money is invested long and short today than 10 years ago, making competition for alpha as fierce as ever.
But history reminds us that markets have a funny way of reversing course when all the passengers lean toward the same side of the boat. Even though I can’t tell you when it will happen, any one of a number of surprises could shift the prevailing winds for long/short managers overnight. Maybe inflation will take hold sooner than most anticipate, rates will rise, and short rebates will boost returns.1 Maybe global sovereign debt problems will be resolved, causing global markets to calm down, focus on fundamentals, and allow security analysis to drive returns. Maybe transparency will improve in the security lending market and stock borrowing costs will fall.
Even without a tailwind, the equity universe contains thousands upon thousands of securities, offering long/short equity managers limitless combinations of securities to buy long and sell short. No other hedge fund strategy has as broad a playing field as long/short equity does, and nothing about the current macroeconomic environment alters the opportunity set for long/short equity managers each day. Although many long/short managers have struggled of late, a number of them have generated sufficient alpha to more than counter cyclical headwinds.
Jeremy Grantham of GMO is fond of reiterating that mean reversion is the most powerful force in investing. It’s something I believe deep in my investing soul. As naysayers throw stones at a strategy that has struggled recently but met its objectives over time, let’s not forget that a little more than 30 years ago, Businessweek proclaimed “The Death of Equities,” accidentally marking the beginning of one of the great bull runs in history.
1. Inflation causes nominal interest rates to rise, which in turn, provides a tailwind to hedge fund returns. For example, short-term interest rates in the United States stood around 3% in the months before Protégé was launched on 1 July 2002. A manager running 150% gross and 50% net (100% long, 50% short) might receive a short rebate on general collateral of approximately 2% (U.S. Treasury bills minus 1%). Today, managers might pay 4% per year to borrow stocks to short because of the combination of a lower starting point (0% short-term rate minus 1%) and a more expensive borrow. The difference hits returns by 3% right out of the gate [50% of book short × (2% – –4%)].
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