Martin Steward asks why some investors are treating long/short equity as an ‘equity replacement’ - and what practical challenges face those who do so
What are hedge funds for? It’s not a trick question, but one increasingly asked by institutional investors as they recognise that their pre-crisis answer - “Hedge funds are an asset class that deliver returns much greater than those suggested by their risks” - was unsatisfactory. They probably never believed this, really. If they did, they would have all put 100% of their assets in hedge funds. But the thinking influenced the way they tended to park all hedge funds in an ‘alternatives’ bucket, making just one assumption about the way they would interact with the core portfolio - that they would be non-correlated.
“It’s important that the investor starts with a clear objective and then tries to select managers that have the risk and return profiles that fit with that objective, in the context of the other types of risk that the investor is taking,” as Eric Stampfel, an executive director overseeing long/short equity strategies at Morgan Stanley Alternative Investment Partners (MSAIP), puts it.
For a pension fund, it was tempting to accept the simple non-correlation argument. Because growth portfolios tend to correlate with bond yields (which often define the value of liabilities), equity bear markets can cause significant falls in funding or solvency ratios. In that context, a growth ‘asset class’ that does not collapse at the same time as equity markets is clearly attractive.
“Drawdowns in funded status can be mitigated by seeking growth from diversified sources of alpha rather than only market beta,” as Gerald Kraus, director of the hedge fund practice at Cambridge Associates, says. “Hedge funds can be a powerful addition to portfolios and a source of alpha.”
There are, indeed, hedge funds that will deliver that kind of risk profile. But pension funds’ allocations were very often dominated, not surprisingly, by the most widespread hedge fund strategy - long/short equity - and that strategy brings with it a lot of equity market risk. That doesn’t mean that long/short equity is useless to pension funds; it undoubtedly offers a more efficient, less volatile, more risk-managed exposure to equity - good in itself, and especially good for those facing risk budgeting constraints from, say, Solvency II or the general trend of de-risking. But recognising that as the strategy’s utility involves re-thinking its place in the portfolio.
“We always thought ‘alternative investment’ was something of a misnomer,” says Alain De Coster, chairman of ABS Investment Management, a fund of funds that specialises in long/short equity. “For us, equity long/short is basically equity risk and should be put in the equity bucket. European and US institutions and the large consultants are recognising this more and more.”
This is becoming something of a consensus. “For too long, institutional investors have assumed that long/short hedge funds are an ‘asset class’ that produces absolute returns,” says Feri Trust’s head of hedge funds Marcus Storr. “Now everyone knows it’s not that simple. When it comes to long/short equity hedge funds allocation with a long-bias I believe that this strategy should be part of an equity asset class allocation.” Ben Funk, head of research at fund of funds Liongate Capital Management, sees more and more institutions treating long/short equity as an equity complement, rather than an ‘alternative’: “This trend will surely increase over time and, ultimately, the two will fuse into the singular category of equity.”
On the face of it, that makes a lot of sense. If you know you are getting equity beta from your hedge funds, it is not only dangerous to under-account for it, it is also inefficient risk budgeting if you don’t make proper use of it: replace some of your core equity beta with your hedge fund manager’s equity beta, and you can potentially allocate more capital to harvest that manager’s alpha.
Of course, nothing is ever that simple. “The European equity long/short universe is currently about 40% net-long,” concedes Ian King, head of active European equities and a hedge fund manager at Legal & General Investment Management. “But my contention - especially under the current circumstances - is that the fundamental tenet of any hedge fund strategy is that it should make money in all market conditions. Putting them willy-nilly into a equity-market bucket maybe looks justifiable if you consider the typical hedge fund exposure, but dangerous if those hedge fund managers are truly hedging.”
So one has to be discerning. But how difficult is that? Long/short equity comprehends a wide variety of sub-strategies, but they can be broken down into four main styles, one of which consistently delivers a slug of beta and three that do not. Market-neutral strategies attempt to net-out the long and short exposures to the market (as well as sectors, market-cap and other systematic risks) to isolate individual stock performance: they will consistently be -10% to +10% net exposed to the market. Event-driven strategies (like merger arbitrage) will also attempt to maintain systematic risk neutrality, isolating exposure to the anticipated corporate events. Top-down, macro-style strategies will try to time markets, resulting in highly-variable net exposure - from leveraged-long to significantly short, over various time horizons. For obvious reasons, these strategies in themselves are less-suited to complementing core equity and may well be best positioned in an ‘alternatives’ or ‘pure alpha’ bucket.
But by far the most widespread style is the fundamentals-driven, bottom-up stockpicker. These investors can deliver significant alpha, but their long books are almost invariably bigger than their short books, and because their time horizons tend to be longer than those pursuing the other three trading-oriented strategies, they inevitably pick up significant amounts of market beta that is tricky to disaggregate quantitatively from the alpha. Surely the prime candidates for equity complement?
“I’m not sure I agree with that,” says King. “Why should anyone choose to be 30% net-long? I agree that strategically most fundamental managers will have a larger book of longs than shorts but, tactically, they would usually have a futures overlay to deal with short-term market gyrations.”
That might be the strategy at LGIM and others, but the funds of funds clearly spend a lot of their time grappling with stockpickers who don’t feel it is their job to swap out their market risk. Lynda Stoelker, head of investment research at Stenham Advisors, says that the approach to this problem is “variable” and that even those who do deploy the “blunt instrument” of an overlay should not assume that it confers market neutrality.
“Theoretically, you can do this,” says Jose Galeano, head of alternatives at SYZ Asset Management. “Practically, the typical long/short equity manager will always have some beta risk - always.” At ABS, where the 90% institutional client base “buys our product as an equity replacement”, that does, indeed, inform a tilt towards bottom-up stockpickers: “As a result we will be, on average, 60% net exposed in a good market and 20% at bottom in a difficult environment,” says De Coster.
In a way, this is just another step in the process we have pursued to arrive at this sub-strategy - having isolated the bottom-up stockpickers, we merely have to isolate, further, those who leave their beta un-hedged.
But does it make sense to dismiss all those talented managers in other long/short styles? It makes it easier if you have a dedicated ‘alpha’ bucket in which to place them - but that doesn’t help if your only requirement of the hedge fund world is to improve the risk profile of your equity exposure. And Stampfel at MSAIP goes further: he says that it is easier to maintain whole-portfolio net market exposure within a tight range if you allocate to a wide variety of sub-strategies, precisely because of the diversification effect.
“If the client wants to construct a portfolio that is 50% net long, we will select some market-neutral managers, some highly net long, some highly variable - so the combination achieves the desired risk profile more consistently given the embedded diversification,” he explains. In other words, if you want to keep your exposure in a range of 40-60%, say, it might be tricky if your funds are all longer-term, fundamental bottom-up stockpickers whose net exposures will tend to move in tandem. If there are some traders in there, perhaps taking a shorter-term view, the likelihood of their net exposures moving in tandem as well is that much lower.
Stoelker agrees. She would be “open-minded” if a client wanted to focus on bottom-up stockpickers, rather than create a diversified long/short equity complement portfolio, and says that these managers are “certainly a higher proportion” of portfolios because there is an inherent “preference” for them at Stenham. You’d be “85% of the way there” if you worked on the assumption that bottom-up strategists would deliver you some beta. But “there are always going to be exceptions”, she warns, and the firm is more likely to create diversified portfolios. “We do it, but you have to really, truly understand how much a macro-driven manager is likely to move his exposure around, given certain circumstances - for example, to enable you to make a decision on what level of exposure to have to your more static net manager.”
Even if you feel confident that you can manage your net exposure within a narrow range over the cycle, however, there is more to it than that. As Stoelker points out, many managers will run a lower-beta short book and a higher-beta long book. While the net exposure might be 50%, because the long book is more volatile the beta-adjusted exposure might be more like 60% - and that will be a moving target related to overall market volatility. “Most managers can give you both numbers, but when they report they tend to just give you the non-adjusted net,” she warns.
It’s rarely possible to find hedge fund managers which satisfy investment objectives solely on the basis of the strategy description, as Kraus says: “Rather than simply asking themselves if they should own long/short equity or ‘more or less equity beta’, investors should carefully evaluate each manager in the context of the plan’s investment objectives and macro-economic outlook.”
Two things become clear: timely position-level reporting helps; and a customised portfolio, rather than an off-the-shelf fund of funds, looks essential. Those are big steps for investors who have often relied on off-the-shelf solutions for small allocations in the past. But a portfolio of long/short equity complement strategies is arguably a more efficient way of retaining some downside protection than a (similarly complex) derivative overlay, because it maintains upside participation. And once you have set out on that route for using long/short, the case for much bigger allocations - and therefore a more favourable cost-benefit trade off - is compelling.