Why I'm A Long/Short Bull, 130/30 Bear

by: Roger Ehrenberg

I'm a long/short bull and a 130/30 bear. Why? Long/short investing gives managers the best opportunity to generate alpha and manage volatility without being constrained by an index. 130/30 funds, conversely, place artificial parameters around both gross and net exposure and lack the intellectual purity of their more flexible long/short cousins.

There were two stories in yesterday's Financial Times that highlighted each of my deeply-held views; this must have been a gift in anticipation of my blogiversary today.

First, an excerpt on the power of long/short investing:

For the year to date it is one of the best-performing strategies, with a return of 9.25 per cent, according to figures from Credit Suisse Tremont. This is ahead of the 7.86 per cent average return for hedge funds across all strategies and beats the 6 per cent year-to-date return on the S&P 500 index.

Long/short managers are therefore among the few groups in the hedge fund industry, alongside event-driven and multi-strategy managers, who can make a convincing case that their often hefty performance fees are justified.

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It is a widely held belief among a broad range of investors that most portfolios should maintain a long-term weighting of between 40 and 60 per cent in equities. But a glance at historical figures shows equity long/short produces superior risk-adjusted returns in comparison with long-only equity in both bull and bear markets. The ABS study attempts to analyse the reasons for this outperformance.

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One of the potential advantages of equity long/short investing is that it provides active management. According to ABS, the differentiation between active managers such as hedge funds and semi-passive managers - including mutual funds and long-only accounts - has been one of the main factors driving hedge fund growth.

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A study last year by Martin Cremers and Antti Petajisto of Yale School of Management shows equity mutual funds that closely track an index significantly underperform those that provide more active management. Laurence Russian, principal of ABS, said this argument could be extended to hedge funds because the vast majority of equity long/short funds do not manage to an index.

Therefore, the ability of hedge funds to provide active management should result in higher risk-adjusted returns and fewer drawdowns over long time horizons, in spite of their higher fees.

Mr Russian added that flexible portfolio management is another factor allowing long/short portfolios to generate superior risk-adjusted returns. The equity long/short strategy gives investors access to both amplified alpha and flexible beta. Alpha is defined as the excess return over the benchmark as a result of stock selection after stripping out the portion of the return attributed to beta, or market exposure.

Flexible portfolio management and its advantages manifest themselves primarily in periods of negative returns or increased volatility. The ability to shift exposure and change from aggressive to defensive stocks allows fund investors to capture the upside of an upward-trending market while protecting capital in down periods.

Next, some questions arising from the proliferation of 130/30 funds:

Rodney Williams, managing director of Feri Fund Market Information, put the cat among the pigeons when he linked the hype surrounding absolute return funds in Monaco in 2004 with that building around 130/30 this time around.

The observation hit home in some quarters with Mark Tennant, a senior adviser at JPMorgan Securities, opining: "There are probably 10 or 12 asset managers in the world with the investment management and risk management skill-sets to manage 130/30 funds."

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The rationale for 130/30-type funds is compelling. Long-only managers can only underweight, not short, stocks they do not like. While this may be fine for large-cap stocks and low tracking error funds, it is problematic for smaller stocks and punchier funds.

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With information ratios (excess return divided by tracking error) of about 3 before fees, these portfolios have outperformed their respective long-only strategies, albeit with higher volatility. "They are doing what it says on the tin; higher volatility and higher return," says Alistair Sayer, investment director, multi-strategy equities at Henderson.

In spite of these arguments, doubts remain. Todd Ruppert, chief executive of T Rowe Price Global Investment Services, warns: "I think there's going to be a lot of blood on the tracks with 130/30 products.

"The view that 130/30 funds will generate a better information ratio presupposes that you have the skills to do it. Most long-only managers don't outperform the market, and that is where their expertise is, and now you are going to let them short."

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Watson Wyatt's Mr Baker argues that if investors have accepted the value of shorting, it is illogical to then restrict themselves to "beta 1" products, although he does accept that 130/30-type offerings can have less onerous fee structures than more traditional long/short funds. "They are hedge funds, and clients need to be aware of that," he says. "Being prepared to relax the short constraint and introduce leverage opens up a world of possibilities, but it doesn't really make sense to limit yourself to a beta of one and 160 per cent gross exposure."

Sometimes even mainstream media can hit the nail on the head. And it is nice to get some validation now and again.

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