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The benefits of liquid alternatives

March 2020

Demystifying long/short equity strategies

When markets encounter turbulence, it is tempting to eliminate stocks from your portfolio. But, for many investors, allocating capital to long/short equities might be a better option.

Global equity markets have suffered dramatic falls over the past two months as the spread of the coronavirus continues to cause significant social and economic upheaval. With a world recession looming, many investors could be forgiven for wanting to further cut back on stocks. Yet doing so at this juncture carries risks.

A rebound, when it comes, would be missed. And, as history shows, once market recoveries take root, they are usually very powerful. Most investors understand this, but remain fearful of a deeper correction. Hourly updates on the spread and effects of the coronavirus naturally chip away at confidence. But there is a way of resolving this dilemma: allocating some capital to long/short (L/S) equity strategies. Such portfolios are designed to offer investors a more flexible approach to equity investing. They help investors retain exposure to equities - a positive in the event of a recovery - but aim to shield them from the worst effects of any further market falls. 

More specifically, they are designed to capture the market’s ‘upside’ when equities are rising but preserve capital whenever the investment climate turns sour.

Such strategies can do this because they use techniques that are unavailable to long-only investment funds. As their name suggests, L/S portfolios take both long and short positions in securities. In other words, they buy shares in companies with the strongest growth prospects and express negative views on firms they believe will  suffer a long-term decline in profitability. Their returns stem partly from a controlled, actively managed exposure to the market, and partly from the security selection skills of the investment manager.

The ability of an L/S strategy to mitigate volatility and limit the scale of losses is particularly important to investors as can reduce the long-term impact of market declines. Indeed the power of compounded returns, a critical concept in the wealth creation process, means that, for example, a 25 percent decline in the value of investments requires a subsequent 33 percent rally to fully recover lost ground.

Because of these attributes, L/S equity strategies are able to perform a specific function within a diversified portfolio: they can serve as a substitute for some or all of the equity allocation with the potential to improve its risk-return profile. 

In recent years, the ability to dampen the volatility of equity investments was not in particularly high demand – equities were surging while the market conditions remained unusually calm.

Low interest rates and quantitative easing were keeping a lid on equity market volatility, creating the conditions for individual stocks to move up more or less in lockstep with one another.

But market dynamics have been changing rapidly in recent months. And the economic effects of the coronavirus could last many years.

As businesses' profit margins come under intense pressure, firms won't be affected in the same way. Companies with poor management and flawed business models will find it harder to service their debts and, therefore, generate attractive returns for shareholders. Those with stronger balance sheets and earnings power, by contrast, will thrive.

When market leaders pull further away from laggards, investment strategies whose returns depend almost entirely on the stock-picking skills of portfolio managers can deliver strong returns over the long run.

Our research also shows that during the two major bear markets of the past 20 years – January 1999 to September 2002 and October 2007 to February 2009 – long/short equity funds offered investors a far greater degree of capital protection.

Overall, then, we believe that current market conditions require a more agile approach to equity investing. Including long/short equities as part of a broader portfolio allocation to stock markets can offer a degree of capital protection but also the possibility to reap rewards once markets recover. That's likely to become even more important in a post-coronavirus world.