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controlling volatility in equities

June 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 appear to be at an inflection point. 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 match the returns of markets when they 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 long-term 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.

We believe February’s market slump could be an indicator of the kind of volatility that could ensure as markets revert to type.

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.

In contrast, the correlation of the returns of the individual stocks that make up the S&P 500 index is at one of the lowest levels of the past two decades (see chart). In Europe, although slightly higher, the correlation has also gone down to reach levels not seen for many years. That is a potentially fertile environment for stock pickers – particularly for long/short managers, who have the ability to generate returns from both strong and the weak performers.
opportunities in divergence
Correlation of S&P 500 constituents with the index, compared to the long-run average
correlation of S and P constituents

Source: Datastream, Pictet Asset Management. Data covering period: 14.04.1999 – 02.05.2018.

We believe that as central banks withdraw monetary stimulus, this period of higher dispersion is set to continue. And as the era of cheap financing comes to an end, corporate fundamentals will diverge: companies with poor management, flawed business models or low margins will find it harder to stay afloat, which in turn will create more short-selling opportunities.

Long/short managers will thus be able to make full use of their bottom-up analysis and stock picking skills, generating excess returns from both potential winners and losers.

Historically, equity long/short managers have tended to secure greater average monthly excess returns over the market during periods of higher interest rates and higher bond yields as highlighted in the chart below. For instance when the 10 year Treasury yield reached its highest level (first quintile), the average monthly excess return of the HFRI Equity Hedge Index relative to the S&P 500 TR Index also scaled a peak.

hand-in-hand with bond yields

Average monthly excess returns for long/short equities versus S&P 500 stocks during instances when 10 year Treasury yields are rising

Long short performance versus bond yields

Average monthly excess return of the HFRI Equity Hedge Index in USD relative to S&P 500 Total Return Index assuming a beta of 0.45 between the 2 indices. Source: Bloomberg, Pictet Asset Management. Data covering period:  31.12.1989-30.04.2018. 

We believe that hedge fund strategies can play one of two roles in a portfolio: they can serve as substitutes or diversifiers. L/S equity strategies can be a substitute for some or all of a long equity allocation and improve its risk-return profile.

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 invest in liquid instruments. And investors can be further protected by the fact that Europe’s UCITS mutual funds framework, which lends itself well to L/S equity strategies, offers great transparency and regulatory oversight.

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 more bumpy.