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Controlling volatility in equities

October 2018

Demystifying long/short equity funds

As global equity markets turn more volatile, long/short equity strategies can help investors to continue generating attractive returns.

Global equity markets are facing a number of headwinds. Economic growth is plateauing, interest rates are rising and valuations look stretched. As a result, after nearly a decade of unusually benign conditions, there are signs that markets are returning back to more “normal” behaviour. That could mean higher volatility and lower returns from mainstream stock markets in future.

That’s an environment for which the long/short (L/S) equity investment approach was designed. Such strategies aim to capture equity upside when markets are rising but preserve capital when the investment climate turns sour. They can do this because they can take both long and short positions in securities. In other words, they can invest in companies with the strongest growth prospects and also establish short positions in firms deemed to be suffering a decline in profitability.

The ability of an L/S strategy to mitigate volatility and limit the scale of losses is particularly important. The power of compounded returns means that, for example, a 25 per cent decline in the value of investments requires a subsequent 33 per cent rally to fully recover ground.

In recent years, the ability to do this was arguably less necessary given both the unusually high returns equities generated and the relative calm of the market.

Artificially low interest rates along with quantitative easing on a massive scale kept a lid on stock market volatility, creating the conditions for individual stocks to move up more or less in lockstep with one another.

But we saw the value of the L/S approach emerge at the start of 2018. In February this year, the S&P 500 suffered a peak to trough drop of more than 10 per cent, while the HFRX Equity Hedge Index – which aggregates the performance of long/short strategies – lost only 3.7 per cent.

And while the S&P500 has recovered and grown from strength to strength, other global markets have been less fortunate. Emerging markets took the bulk of downside amidst wobbles in Turkey and Argentina and trade tensions between the US and China, which coupled with domestic concerns around growth and currency depreciation, put pressure on local equity markets, as illustrated by the MSCI Golden Dragon, comprising China, Hong Kong, and Taiwan equities (chart 1).
Year-to-date returns of S&P500, MSCI Emerging Markets and MSCI Golden Dragon in USD
year to year return

Source: Pictet Asset Management, Datastream, as of August 2018

Historically, in such times of turbulence, investors have dialled down their equity exposure and turned to bonds. But today that strategy is less likely to work: bonds appear to have lost some of their diversification benefits, tending to both rise and correct in unison with equities in recent years.

1-year correlation of MSCI Golden Dragon and S&P 500 constituents with the index
1 year correlation

Source: Pictet Asset Management, Datastream, as of August 2018

In contrast, bottom-up stock investing in Greater China – particularly for long/short managers, who have the ability to generate returns from both strong and the weak performers – has the potential to be rewarded given the lower correlation between individual stocks to the overall market in contrast to developed markets such as the S&P (chart 2). 

We believe that as global central banks withdraw monetary stimulus, this period of higher dispersion is set to continue. Long/short managers will thus be able to make full use of their bottom-up analysis and stock picking skills, potentially generating excess returns from both winners and losers.

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. What’s more, unlike some other diversifying asset classes – such as real estate or private equity – long/short equity portfolios typically invest in liquid instruments. 

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 downside protection – insurance that’s likely to become even more important as markets become bumpier.