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Equity long/short strategy is a strategy through which a fund manager buys
undervalued stocks which are expected to outperform,
and short sells overvalued stocks which are expected
to underperform. This type of portfolio is sometimes
called “market neutral”, although strictly
speaking a market neutral portfolio is achieved
only if the long exposure balances the short exposure
so as to eliminate systemic market risk. Some
market neutral funds even go one step further
to eradicate industry risk by making pair-wise
bets within each sector, but such an objective
can only be achieved if strict risk controls are
kept constantly in place. Market neutral portfolios
are perceived to be a lower risk type of hedge
fund. In reality, however, most equity long/short
funds tend to range between a slightly net short
position to 100% net long, depending on whether
the manager is bullish or bearish on the market,
although recently some have widened those ranges.
The beauty of an equity long/short strategy is that it can fully
take advantage of the fund managers’ stock
picking capabilities. Note that the end-result of
the fund managers’ stock research is the identification
of winning stocks ie. the buy candidates. On the
flip side, those stocks which fail this test are
identified as the losing stocks and could become
the short candidates. In other words, alpha1
can potentially be generated from both the long
and the short sides, as opposed to a traditional
long-only fund where alpha is generated from the
buy side only.
In order to profit from a long/short strategy, the
short picks need not necessarily drop or the long
picks need not necessarily rise – it will be
profitable as long as the long picks outperform
the short picks so that a positive spread can be
pocketed. Of course, if everything goes against
the fund manager and those stocks which constitute
his long positions underperform, while those stocks
which he shorts outperform, it will be a double
whammy.
Some equity long/short managers may employ leverage
to gear their stock bets if they have a very strong
conviction in their stock selections. The logic
behind this is that a long/short fund can buy more
good stocks without taking as much risk as a fund
which merely buys and does not short. With the added
dimension of downside risk management through the
shorts, one can be bolder in pursuing stocks with
strong appreciation potential. This could potentially
increase the fund’s return while minimising
broad market risk, but stock-specific risk will
increase in this case.
The ability to short individual stocks is often
limited in less developed markets and among smaller
stocks, either due to low liquidity, regulatory
restrictions or lack of suitable instruments. Paradoxically,
these are often the areas with the least market
efficiency and hence the biggest opportunity to
generate alpha. In that case, how can we “neutralise”
our long positions or exploit the pricing anomalies
on the short side? Fund managers may hedge overall
market exposure through selling the broad market
indices in the futures market or buying put options.
If these are not available either, then proxies
such as ADR/GDRs (American Depositary Receipts and
Global Depositary Receipts) trading in other markets,
OTC (over-the-counter) derivatives or exchange traded
unit trusts could be valuable tools. However, you
must be careful to distinguish between aggressive,
speculative hedge funds that make highly leveraged
directional bets using derivatives and those that
use derivatives primarily to hedge downside risks.
Bear in mind that while the maximum you can lose
on a long position is your invested capital, there
is no ceiling on how much you can lose on a short
position as there is no limit as to how high a stock
can go. That is why risk control is so important
in hedge fund management.
Equity long/short strategy is most valuable when there is
a big divergence of performance across stocks (of course that
hinges on the fund manager’s ability to identify those
winners and losers), or when broad market volatility is high.
In the first case, such a strategy could produce superior
returns even if the average market performance is flat (ie.
with rising stocks offsetting declining ones). In the latter
case, a long/short approach should be able to provide much
smoother returns than the general market. In this sense, it
can serve to enhance returns and/or reduce volatility to produce
a better risk-adjusted return.
The above information is shown for illustrative
purposes only. It is not intended and should not
be interpreted as the performance of an actual
investment. An equity long/short strategy can also help cushion
the downside during a bear market. But of course,
everything comes with a price as this strategy
typically underperforms the traditional long-only
approach during a bull market. Given its low correlation
with traditional asset classes, this type of fund
is classified under “alternative investment”
in the investment universe. Investors should consider
buying such hedge funds to enhance the risk/return
profile of their existing portfolios, ie. to get
“more dollar bang for each risk buck”.
Allocation can be adjusted between equities, bonds,
cash and hedge funds to arrive at your desired
level of risk, while maximising your potential
return. Depending on your objectives and risk
tolerance, in general we recommend an allocation
between 5-15% to hedge funds. As opposed to a long-only fund whose return is
derived more from broad market movement than manager
skills, an equity long/short fund relies largely
on the manager’s stock picking capabilities.
Therefore, in choosing which equity long/short
fund to buy, investors should pay attention to
the fund manager’s research resources, investment
process, risk control, experience and consistency
of performance. This can help discern real expertise
from pure luck. If you have a chance, try to check
upon the fund manager’s performance attribution
reports to unveil his strengths and weaknesses
(ie. where he has added or lost value). An analysis
of his stock rankings would definitely help too.
For example, at JF Asset Management we constantly run performance
analyses of the stocks our fund managers rank in each market.
We have a ranking system of 1 to 5, with 1 being those stocks
which we like most and 5 being those we most dislike. We then
look at the aggregate performance of those stocks of the same
rank to see if they outperform or underperform over time as
expected. The following chart for the Hong Kong stock market
confirms that JF Asset Management has been able to identify
both the winning and the losing stocks in a consistent manner.
This is exactly the type of managers that you should look
for.
Source: JFAM (with monthly rebalancing)
* Discontinued between 12/03 and 3/04 as there were no
5-ranked stocks during that period
1Alpha refers to the extra
return above the broad market return and is typically
used to measure a fund manager’s value added.
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