Building A Better Portfolio Using Long/Short Equity

by: 361 Capital
Summary

Long/short equity serves investors better when it makes up a portion of their traditional “core” allocation of equity and fixed income, rather than a component of an alternative allocation.

Historically, long/short equity funds have come close to matching the performance of equities, but with less volatility and reduced drawdowns.

When correctly positioned within a broader portfolio, strategies that reduce volatility and minimize drawdowns, such as long/short equity, can help investors stay on track with their long-term investment objectives.

Long/short equity funds are the largest category of alternative mutual funds, but their popularity hasn’t always translated into proper portfolio placement. Long/short equity is often square-pegged into an alternatives or satellite allocation. A closer look at a long/short equity fund’s characteristics, however, reveals why it should be a core holding alongside traditional stocks and bonds.

Long/Short Funds Fortify the Traditional Stock and Bond Allocation

Many allocators break client portfolios into a “core” or “traditional” bucket of equity and fixed income, and a separate “satellite” or “alternatives” bucket—catch-all phrases that include commodities, real estate, high yield or floating rate debt, hedge funds and other investments that diversify the portfolio. The misleading alternatives label applied to long/short equity funds makes it easy to associate them with the latter category. But that’s not how the strategy behaves.

Long/short equity funds invest in stocks, so not surprisingly, the category has a relatively high correlation to equity markets, (0.67 as of 12/31/2018). However, its ability to short stocks often puts the fund’s net exposure to equities below 100%. This makes the strategy behave like an enhanced version of a stock or bond allocation.

As the table below shows, long/short equity strategies have come close to matching the performance of equities, but with essentially the same level of volatility as a 60/40 stock and bond portfolio (as measured by standard deviation). Just as important, the maximum drawdown of the typical long/short equity strategy was considerably lower than for the S&P 500, and even lower than a 60/40 portfolio that is designed to protect against a market crash.

Annualized Return

Standard Deviation (Volatility)

Sharpe Ratio Maximum Drawdown
S&P 500 Index 9.07 14.45 0.50 -50.95%
Barclays US Agg. Bond Index 5.09 3.54 0.72 -5.15%
60% S&P 500 Index/40% Barclays US Agg. Bond Index 7.75 8.82 0.61 -32.54%
Credit Suisse Long/Short Equity Index 8.14 8.93 0.65 -22.00%

Source: Morningstar 1/1/1994 to 12/31/2018

Reduced drawdown has important effects for investors—both real and psychological. With only a limited amount of time to save for retirement, not every investor can wait for the “average” return of equities to make them whole after a severe market downturn. For example, it would take an investor 4 years to make up for a 20% decline in the value of a $500,000 portfolio (assuming a 7% annual return). And even investors with longer investment horizons can get scared away when stocks are in free fall—exiting equities at precisely the wrong time.

Long/short equity strategies seek to minimize drawdowns and can help investors stay on track with their long-term investment objectives … but it helps if the long/short equity strategy is correctly positioned within a broader portfolio.

Save the Satellite Sleeve for True Alternatives

Long/short equity funds belong in a core portfolio because they play a valuable role enhancing its risk return/profile. Conversely, if allocators place the strategy within the satellite or alternatives bucket, they risk inadvertently creating a portfolio with too much equity exposure.

The alternatives allocation should be reserved for managed futures strategies, convertible arbitrage strategies or other asset classes and strategies whose return streams are truly uncorrelated to equity markets.

Investors should let the alternatives allocation do the work of diversifying the broader portfolio, while long/short equity strategies fortify the core.

The views expressed are those of the authors at the time created. These views are subject to change at any time based on market and other conditions, and 361 Capital disclaims any responsibility to update such views. No forecasts can be guaranteed. These views may not be relied upon as investment advice or as an indication of trading intent on behalf of any 361 Capital portfolio.

This 361 Capital article is not intended to provide investment advice. This paper should not be construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security by 361 Capital or any third-party. You are solely responsible for determining whether any investment, investment strategy, security or related transaction is appropriate for you based on your personal investment objectives, financial circumstances and risk tolerance. You should consult your legal or tax professional regarding your specific situation.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.