The long and the short of sustainable returns
While the merits of short selling – and its impact on markets – will always be hotly debated, the fact remains that short selling plays an important role in ensuring that securities are priced correctly relative to fundamentals. It also provides an additional opportunity for portfolio outperformance.
Traditional long-only fund managers are, by definition, skewed towards identifying opportunities to buy, whereas those managers that adopt a long-short approach can take a position in a range of investment opportunities across a much wider spectrum of investment options through both buying and short-selling.
The most obvious benefit of long-short investing is that it offers investors the ability to benefit from both rising and falling prices.
A long-short equity strategy seeks to profit from share price appreciation above the index in its long positions as well as from price declines below the index in its short positions.
A long-short fund has double the opportunity for alpha. It can focus on short selling a range of stocks with weak investment characteristics while reinvesting the proceeds in long positions in preferred stocks. This combination of long and short provides managers with flexibility and enables more active decision making.
Essentially, a long-short approach also enables portfolio efficiency to better capture alpha insights while diversifying away unintended risk exposures. This is particularly relevant with the current uncertain market outlook both globally and domestically.
Market outlook
Equity markets have surged back towards highs in recent times as a combination of a dovish pivot by the US Federal Reserve and positive progress on a trade deal between the US and China has bolstered risk appetite.
The rebound in markets has been unequal, however, with the rally concentrated in technology, REITs, utilities and resources while there has been more moderate participation from cyclicals. This indicates to us that that the market is reacting more to the improvement in the liquidity environment and lower bond yields than it is to improved expectations for growth.
Domestically, the housing market continues to decline as credit tightness bites on clearance rates, prices and new dwelling construction. Meanwhile, recent reads on GDP growth, housing starts, retail sales and new job adds all point to further weakness ahead.
On the positive side, the terms of trade have received a significant boost from higher iron ore prices and this will help to foster an ongoing recovery in the resources sector. There is also a reasonable tail of infrastructure work which will provide some offset to weaker household consumption. Of course, the exchange rate also provides a relief value to the economy if growth takes a hit, especially if the Reserve Bank of Australia moves to cut rates further.
The uncertainty in all of this was the Federal election, and the outcome would have been keenly watched by markets.
Portfolio protection
In this environment, investors would be well served by reviewing their investment approach and ensuring their portfolios are positioned for an appropriate risk adjusted return. This means actively managing portfolios and looking to incorporate adequate diversification.
A long-short investment approach, for investors with an appropriate risk return profile, should be part of this.
Long-short equity strategies aim to provide investors with returns that beat the benchmark, whatever the market conditions. In managing a long short fund, a manager doesn’t just look for the good news stories in the way that traditional Australian equity managers – it can take advantage of negative views of stocks and sectors, as well as weaker fundamentals.
Because it is focusing on short selling a range of stocks with weak investment characteristics and reinvesting the proceeds in long positions in preferred stocks, a fund manager has a large degree of flexibility which enables more active decision making.
This is particularly relevant in the local context, given that the Australian share market is small by global standards and is dominated by a small number of very large companies.
When using a benchmark for constructing an investment portfolio, such as the S&P/ASX 200 Accumulation Index, the performance of a traditional fund which only takes long positions will be determined by the size of the fund’s shareholding of these very large companies relative to that company’s weighting within the benchmark.
By contrast, a fund that is also able to take short positions in securities by borrowing securities from other holders and selling on market and reinvesting the proceeds in other long positions has a larger set of investment opportunities and gives more opportunity to outperform the fund’s benchmark.
Risk/return trade off
That said, a short investment strategy is not for all investors, not least because returns and exposure are amplified on the upside as well as the downside. It is true that poor stock selection in a shorting strategy may provide a worse investment outcome than poor stock selection in a long only approach.
Manager and strategy selection are important. Managers that have a good track record over a long period of time should be preferred, particularly those that have been through various market cycles.
Another important determinant factor of returns is risk control. Managers with inappropriate risk modelling will find it difficult to consistently outperform. An effective way to ensure that is to invest in a manager that uses a combination of quantitative and fundamental investment processes.
The strength of quantitative investing is the breadth of information that captures and enables a transparent and objective assessment of a company’s relative prospects.
A well-designed quantitative process seeks to exploit particular behavioural biases that are exhibited by investors and can be explicitly measured through precisely defined factors. These factors generally fall into the categories of either value or momentum and can be implemented through bottom-up research or top-down research.
The benefit of this approach is the significant amounts of company detail that can be unearthed and used to generate insights into its future prospects and likely investment returns. It provides an enormous amount of breadth to the investment process and enables a company’s likely outperformance to be assessed in an objective manner.
The advantage of the fundamental approach is the level of detail that can be gathered on a particular company and level of investment insight that can be obtained from a detailed knowledge of a company’s operations.
Essentially, a quantitative process provides breadth and objectivity for stock selection while the fundamental process delivers detailed high conviction insights for investment.
Investing is an art, but with appropriate science/quantitative tool, investors can expect to generate higher return while controlling the risks and hence delivering outperformance over the long term.
Jun Bei Liu is portfolio manager of the Tribeca Alpha Plus Fund.
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