Equity long/short managers should be celebrating the recent volatility in the markets. After all, they’ve endured a drubbing since the end of the Financial Crisis as beta has raced past them. While this should be expected to some degree, the level of outperformance has been significant. In fact, the average long/short manager has failed to even generate a positive upside/downside capture ratio over this cycle. In 2015, the strategy showed some promising signs of life, posting positive returns while the market was mostly flat. But, during the January decline, some very good long/short managers fell more than the market and are still in the red as the market has recovered. Given the typical net exposure to the market (between 40 and 70%), this outcome has (rightly) left many advisors scratching their heads.

When does the sun shine again on the strategy?

In retrospect, any attempt to own anything other than unhedged beta over the past 7 years was foolish as the Fed pulled out all stops to reflate risk assets. To a large extent, they succeeded in raising all ships which also served to tamp down the dispersion in returns between winners and losers in the market. For long/short managers, dispersion in the market is very helpful in terms of generating spread between their long and short books.

But now we may be entering an environment where the Fed doesn’t have the same ammo (or inclination) to suppress volatility as it has in the past and broader market indexes may be more vulnerable. If history is any guide, long/short managers should have a leg up in flat, choppy markets as investors become more discerning about valuations. If markets roll over, long/short managers have a distinct advantage given their hedged position to the market. Given we’re 7 years into this bull market, either of those two scenarios seem more probable than a big movement up in the market.

But, as is the case with all hedge fund strategies, manager selection is critical and the role of the short book becomes increasingly important in this environment. As a result, understanding the manager’s approach (and skill) in shorting is very important. If January was any indication, managers that run a short book of individual names (or very narrow indexes) may have an advantage over the ‘hedgers’ who short broad market indexes as the latter tend to be less volatile and may provide less spread and, therefore, less efficient downside protection.

For advisors who have dipped a toe in long/short over the past few years only to conclude it underperforms beta, they may want to re-evaluate its role in the overall equity allocation given the environment we face in the years ahead.

Van Etten Consulting provides training and consulting services to Asset Managers and Broker/Dealers. The information contained herein represents the opinions of Van Etten Consulting and is intended for investment professionals only and should be viewed as educational content and not be construed as investment advice.

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by | Mar 21, 2016 | Alternatives, Featured

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