As we enter the second half of 2020, many investors have turned to alternative assets to protect them from the economic downturn. No one likes to lose money, and Warren Buffet (Founder of Berkshire Hathaway) said, “The goal is simply to survive the disaster with the ship intact.”
The Oracle of Omaha is looking at reducing his risk to return ratio, translating into more downside protection. Yet, how can individual investors protect themselves from large market corrections effectively? Long/Short equity is a classic hedge fund strategy that historically purports to generate higher returns with lower risk than equity markets. But does it make sense?
What is a long-short fund?
Long/short equity funds (L/S) seek to reduce the systemic risk, or market risk, for an investor’s portfolio. This type of risk is the possibility of an investor experiencing losses due to factors that affect the overall performance of the financial markets. The investment strategy seeks to go long (or holding a stock), believing the price will go up on undervalued companies, while simultaneously going short (or selling a stock on credit), betting the price will do down on overvalued companies.
If the value of an investment (i.e., a stock) trades exactly at its intrinsic value, then it’s considered fairly valued (within a reasonable margin). However, when an asset trades away from that value, it is then considered undervalued or overvalued. In terms of the Long/Short strategy, overvalued means investors are paying too much for an investment and undervalued meaning investors are getting a bargain. What makes this strategy unique is that it takes advantage of securities that are both over and undervalued.
Most times, investors pick a side. When a fund is 100% long, it only takes advantage of undervalued securities by betting the market will eventually reward the company by recognizing its true value. Short-sellers try to find the opposite, where they think the market is going to punish overvalued companies. Long/Short exposes an investor to upside and downside potential and allows for exploiting profit opportunities from price changes in each direction.
Each fund determines in-house what they believe is under or overvalued through proprietary financial analysis. Based on the manager’s research, the winning become buy candidates while stocks that are identified as losing stocks become short candidates.
Paying for Performance
An L/S strategy should help provide downside protection during a bear market or correction. Yet, everything comes with a price. L/S funds have struggled during elongated bull markets since they try to play both sides of price movements. One of the largest risks in this strategy is having your short position over-performing while having a long position under-perform. This is precisely what happened over the last 10 years. Funds try to battle this using leverage, or borrowed money. By doubling down on their biggest winners, they attempt to make up for the short-term losses.
Another downside to this type of fund is the cost. Since these funds are very actively managed, they tend to have higher expense ratios. Paying for some of the biggest names in finance isn’t cheap and the cost is passed on to the investors. Long/short equity funds averaged a 1.9% expense ratio, compared to a .57% expense ratio across all mutual funds, according to Blackrock.
Is a long-short fund worth it?
With investments, we always talk about “bang for your buck.” So, is the risk of L/S worth the reward? This turns out to be a complicated question with few reliable answers. When trying to compare L/S solutions that are publicly traded, it turns out there is no good set of definitions, or at least none that are strictly adhered to by their fund managers. When looking inside of L/S funds, there are many that have nearly no short positions, leaving investors to ponder where the downside protection is.
Non-publicly traded solutions have their own set of issues. While there are indices that purport to aggregate L/S hedge fund performance, the data is unreliable. Fund managers can choose to report or not, and do not have to follow GAAP accounting. This leads to a meaningless benchmark.
In theory, L/S presents investors with an intriguing opportunity. If the Nobel Prize winners say that value should outperform growth, then why not go long on value and short growth?
It boils down to execution. Fund managers get to pick the winners and short the losers on a seemingly ad hoc basis. Given we know that stock pickers can’t do better than chance on the long positions, why take them at their word they can do it on the short ones? Pair that reality with a high expense ratio, and what you get is yet another complicated, expensive investment strategy with no provable upside.
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