Long-short investing suited for the times
The renewed market stress following recent geopolitical unrest has created heightened fear among investors who were already concerned about higher interest rates, high inflation and slowing economic growth.
However, the volatility has created a rich pool of investment opportunities which skilled fund managers can exploit through long-short equities strategies.
While long-short funds are similar to regular long-only managed funds in that investments are pooled and professionally managed, managers don’t follow a benchmark, and so are often considered contrarian. Managers are typically more flexible in their investment strategies which aim to delivering positive returns over the short and longer term and even when markets are falling.
Long-short strategies
A long-short equity strategy is grounded in the belief that markets are inefficient. This creates opportunities for investors to take advantage of mispricing in financial markets and seek out opportunities that differ from the prevailing market sentiment. Importantly, long-short investing seeks to generate returns from stocks going up in price but also going down through short selling.
This contrasts with a long-only investment strategy that seeks to add value over time by investing in - and holding - shares with the view that the value of the company’s share price will appreciate over time.
Unlike long-only investments, short selling involves selling shares that you do not own. In its simplest form, short selling involves borrowing a stock (typically from a broker) with a view that the stock will go down in value, at which time the manager can buy the stock back at a lower price and return the borrowed stock at a higher price - with the difference in price being the additional return generated from short selling.
Depending on the investment approach, a manager’s skill set and other factors such as the size of the strategy, managers may short individual stocks or market indices. Shorting can be executed by either borrowing physical stock or using derivatives such as contracts for difference (CFDs) to express a short position.
However, this investment approach is more complicated than long-only investing. Short selling requires rigorous research and a strong conviction by fund managers in the face of opposing views.
The investment approach is driven by fundamental research that invests in out-of-favour securities which are significantly mispriced due to structural and/or cyclical concerns.
That said, long-short investing offers several benefits for investors, including the potential for long-term capital growth and good performance through active management from both the long and short side. Long-short investors also allows investors to profit from falling markets through a fund manager’s skill in selecting mispriced stocks.
Long-short strategies can be incorporated into investors’ portfolios via several ways. The first decision to make is which asset class do long-short equity strategies fit within? Portfolio constructors tend to have different views on where long-short strategies belong within the context of a diversified portfolio. Arguably, they can fit in within the equity part of a portfolio, or within an alternative asset allocation depending on the type of strategy.
Furthermore, it is important to consider the role a long/short strategy plays within a portfolio. This will vary based on the individual fund manager’s investment philosophy, style and overall risk-return profile and the overall approach to portfolio construction taken by the investor.
In a ‘core-satellite’ portfolio approach, for example, the ‘core’ allocation will typically comprise of a lower cost index tracking strategy, a long/short strategy may fit within the ‘satellite’ portion of a portfolio. This is typically where the portfolio constructor wants a strategy with the ability to generate alpha, provides a differentiated exposure to a traditional long only strategy and is not easily replicated via an index strategy.
A long-short strategy may complement other satellite positions within the portfolio that provide a differentiated exposure to a broad index such as global mid/small caps and emerging markets. The diagram below is an illustration of a core satellite portfolio for a diversified global equities portfolio.
Considerations when choosing a long-short strategy
Other considerations are important for investors in choosing a long-short investment manager. First, managing long-short portfolios is very different to managing a long-only portfolio. Long-short investing requires experience in shorting stocks. A manager who has managed long-only portfolios may not have the requisite skill to manage a long-short portfolio. Therefore, when considering investing in a long-short portfolio, it is important to consider a manager’s experience and track record in managing a long-short strategy.
It is also important to consider risk management and having a process for managing investment risks from more complex investment strategies. Examples include having stop-loss rules in place which are used to limit the loss attributed to a short position. Outside of an individual manager’s skill, there are market environments that are better suited to certain sectors, investment styles or strategies.
Long-short equities are no exception. An environment with higher stock dispersion or volatility, such as the present, is generally more conducive to long-short strategies.
Fund capacity is also an important consideration. Generally, the larger an equities fund is in terms of funds managed, the harder is becomes to generate alpha. How frequently a fund manager trades within a portfolio can also have implications on how big a portfolio can get before it impacts the ability of the fund manager to generate alpha.
In the case of long-short strategies, the ability to effectively short stocks can also become more difficult as funds under management grows. One of the signs that a long-short strategy is getting too large is when a manager who has traditionally shorted stocks shifts to shorting indices as their ability to short individual stocks reduces. In selecting a long-short manager, it is therefore important to consider how large the fund is and whether the manager’s investment process is repeatable the larger the fund gets.
Overall, long-short strategies can provide an additional source of diversification and alpha to a portfolio. The ability to short within a portfolio also brings added complexity and risk, with a high reliance on manager skill, so it is important to conduct the appropriate due diligence before deciding whether to invest in a long/short strategy.
Lukasz de Pourbaix is global cross asset specialist at Fidelity International
Recommended for you
Next year there are more reasons than most to start with a fresh perspective when it comes to reshaping investment strategies, writes Dan Farmer.
For many investors, the promise of ESG investing has been evasive and confusion around the term has led to many investors becoming disillusioned with their portfolios, writes Tony Adams.
Advice businesses that directly contract offshore workers are exposed to legal challenges in light of a recent Fair Work Commission decision, writes Danielle Cornelissen, CEO and founder of 5 ELK.
Referral arrangements with other professional advisers, known as Centres of Influence, can help financial advisers to build client relationships, engagement and trust over time.
