The long/short approach


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The long/short approach

  1. 1. UCITS The Long/Short Approach A rationale for equity substitution February 2010 Robin Lowe, CAIA, Head of Equity Hedged (US & Europe) Patric Gysin, CFA, Head of Equity Hedged (Asia & Emerging Markets)
  2. 2. UCITS Glossary of terms Alpha: the component of investment return that can be attributed to the skill of the fund manager(s). Beta: the component of investment return provided by (positive or negative) market movements (alpha +/- beta = total return). Drawdown: a term used to describe the extent of a decline in asset value from peak to trough in any given cycle. In the context of equity long/short strategies, drawdowns typically occur during bear markets and the extent of the drawdown of the fund is often compared to the percentage fall in the market. Leverage: a term used to describe the degree to which an investor utilises borrowed money or speculative derivative positions to enhance investment returns. In the context of an equity long/short approach, fund managers typically use some or all of the proceeds of selling stock short to ‘lever up’ their long exposure, but it is very unusual for excessive borrowed capital to be deployed. Liquidity: a relative term describing the speed at which an asset or assets can be converted into cash (liquidated) and vice versa. MSCI World: a widely used composite index of capital-weighted stocks developed by Morgan Stanley Capital International, which acts as a proxy for world stocks when assessing the relative performance of any portfolio with global asset exposure. Prime broker: in the context of a long/short equity approach, a prime broker acts as the intermediary between the two counterparties involved in short selling, by matching a stock borrower (equity long/short manager) with a stock lender (typically a pension fund or large institution). The prime broker also collects margin payments from short sellers should the market price of the stock move against them. Short selling: a trading technique whereby an investor (long/short manager) makes an agreement with a ‘prime broker’ to borrow stock from a stock lender. The stock is then sold by the long/short manager with a view to buying it back at a lower price in the future. Stock lender: any party holding a long position in a stock can earn a lending fee by providing a prime broker with the opportunity to find an equity long/short manager that wishes to ‘short’ the same stock. Lenders are typically large institutional investors who wish to ‘own’ the stock over the long term 2/12
  3. 3. UCITS Introduction Despite delivering lacklustre returns for over a decade, stocks continue to play a hugely significant role in the performance of many investment portfolios. Small private investors and large institutions alike allocate to equities simply because they have investment objectives which cannot be met or liabilities that cannot be funded through the rates of return currently available from other traditional asset classes. In today’s uncertain environment, the three attributes investors should target are liquidity, transparency and asymmetric returns. Traditional long-only equity funds provide two of the three but the pronounced inconsistency in year-on-year investment returns presents severe difficulties to those making strategic asset allocation decisions. Executive summary Equity long/short managers are able to generate investment returns with extremely attractive dynamics – a high participation in the upside potential of stock markets combined with a much lower correlation to equities during bear phases The primary return driver for equity long/short strategies is alpha while market beta will largely dictate whether a long-only discipline produces positive returns A well constructed portfolio of alpha-generating equity long/short managers should produce superior risk-adjusted returns to any long-only discipline The rise and fall of passive investment In response to scathing criticism about its inability to justify active management fees with value-added investment performance during the 1970s, the traditional asset management industry set about developing synthetic methods of replicating index performance (the first index fund was established by Wells Fargo in 1973). Consequently, by the late 1990s, it had never been easier or cheaper to acquire stock market beta by virtue of the extraordinary range of tracker funds which had become 1 widely available. At the same time, academic research shows that the average equity risk premium was wider between 1982 and 1999 than during any other comparable period in history. Diversification was therefore a concept to avoid rather than embrace and investment profits were largely generated as a function of stock market risk. The 1990s was a decade in which beta triumphed over alpha, but the early years of the new century have been characterised by efforts to segregate these two components of investment performance. This development recognises that beta is easy to replicate but Traditional long-only constitutes an unreliable source of return, while alpha is expensive to acquire and should be rewarded appropriately. The issue for traditional equity disciplines in this managers levy a fee for respect is that a fee for active management is levied, yet much more beta than alpha is delivered. active management, but deliver more beta than alpha The Barclays Capital ‘Equity Gilt Study’, refers to the overvaluation of stock markets at the end of the 1990s as being ‘the most extreme of the past century and indeed of recorded stock market history’. In the period since then, many investors have discovered to their own cost (i.e. through experiencing drawdowns of up to 50%) that cheap beta is far from the ultimate investment solution. 1. Source: ‘Triumph of the Optimists’ Dimson, Marsh and Staunton (2002). 3/12
  4. 4. UCITS In recent months, we have seen equity risk premiums trend strongly positive once more and some of the traditional arguments in favour of equities remain compelling. However, it seems increasingly likely that investors will need to diversify beyond the traditional investment strategies in order to generate the excess risk premiums that they benefited from during the final stages of the 20th century. A much greater focus on the management of downside risk is also a critical issue. The case for equity substitution The rationale behind a long/short strategy is to achieve consistent investment returns through a low correlation to falling stock markets – as demonstrated in the chart below. A low correlation to falling stock markets (in USD) 1 January 1990 to 31 December 2009 End value 16000 HFRI Equity Hedge (Total) Index USD 14,256 12000 MSCI World Index hedged to USD (price return) 8000 4000 Index value USD (log scale) End value 2000 USD 1,834 1000 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 ‘Winning by not losing’ – avoiding large drawdowns Equity long/short managers have the ability to bring more advanced investment techniques into mainstream asset management in an intuitive and transparent manner. will significantly enhance It is certainly the case that the long/short approach provides a number of benefits which should help investors to meet strict objectives regardless of the trading environment. average returns Moreover, it can either be deployed as a stand-alone strategy or as an additional component of a broader equity allocation. Large losses undermine long-term returns and should be avoided where possible. The Wall Street Journal refers to this as ‘the cruel math of big losses’ – when a large drawdown is incurred, a much bigger gain is required in order to restore parity. This problem can be exacerbated by negative compounding which occurs during extended bear phases. Consequently, the investment return earned can, in practice, be significantly lower than that implied by the arithmetic return. Source: Bloomberg. 4/12
  5. 5. UCITS Distribution of real annual equity returns over 109 years 8 7 6 5 Frequency of monthly return 4 3 2 1 0 -50 % -45 % -40 % -35 % -30 % -25 % -20 % -15 % -10 % -5 % 0% 5% 10 % 15 % 20 % 25 % 30 % 35 % 40 % 45 % 50 % 55 % 60 % Source: Adapted from the Barclays Capital ‘Equity Gilt Study’ 2009. At first glance, the above chart would not give a long-only equity investor any major cause for concern because the largest positive return exceeds the largest negative return. For example assuming the worst case scenario of an investment returning -50% in the first year and the best scenario of +60% in year two, the arithmetic return is +10%. However, the investment return is actually negative as a rebound of 100% is required to counteract a drawdown of 50%. The actual value of the investment would therefore have declined by 20%, rather than appreciating by 10% as the arithmetic return would imply. Consequently, the fundamental justification for the long/short equity approach is that A ‘short book’ is essential to the very existence of a ‘short book’ is essential to ensure a degree of downside protection in the event of an abrupt market reversal. The downside insulation exhibited ensure a degree of by equity long/short strategies is the key to their greater consistency, and the attractive performance dynamic it creates is often referred to as an asymmetric return profile. downside protection in an abrupt market reversal 1 Worst six quarters for global equity markets (in USD) 0% -5 % -10 % -15 % Quarterly return -20 % Man Long Short Equity Global USD I MSCI World Index hedged to USD (price return) Dec 08 Sep 02 Sep 01 Jun 02 Mar 08 Sep 08 1. Source: Man database and Bloomberg. Period of analysis: 1 August 1999 to 31 December 2009. There is no guarantee of trading performance and past performance is not a reliable indicator of current or future performance. 5/12
  6. 6. UCITS In technical terms, the return distribution of long-only equity investment can be described as ‘negatively skewed’ or having ‘fat tails’. That is to say the probability of extreme market events (2000, 2008 etc) is high, and the mean return is typically lower than the median return drawn from the same data sample. The negative skew is unavoidable because long-only managers control their tracking error relative to a benchmark index and are The event risk associated therefore subject to market event risk. Conversely, long/short managers are focused on constructing portfolios based on with long-only investment high-conviction security selection and total, rather than benchmark-relative, risk. As the primary return driver is manager skill rather than stock market beta, the event risk can largely be eliminated associated with long-only investment can largely be eliminated. In a portfolio context, it is possible for a long/short equity manager to aim to substantially participate in the upside of equity markets, earn positive returns in sideways markets and preserve capital in bear markets. By virtue of the lower level of volatility inherent in the long/short approach, these disciplines also generate superior risk-adjusted returns in comparison to traditional long-only indices, as illustrated in the chart below. In addition, the different return dynamics make equity long/short an ideal diversifier for long-only exposure and an allocation to (e.g.) Man Equity Hedged Strategies can significantly enhance the overall efficiency of any equity portfolio. 1 Superior risk-adjusted returns (in USD) 6% 4% Man Long Short Equity Global USD I 2% S&P 500 TR 0% W orld stocks MSCI Europe Index (USD) -2 % FTSE All Share Price Index Annualised return -4 % -6 % 6% 8% 10 % 12 % 14 % 16 % 18 % 20 % 22 % Annualised volatiliy 1. Source: Man database and Bloomberg. Period of analysis: 1 August 1999 to 30 November 2009. There is no guarantee of trading performance and past performance is not a reliable indicator of current or future performance. 6/12
  7. 7. UCITS An overview of equity long/short The approach The ‘long’ aspect of any equity long/short strategy adheres to the conventional Equity long/short managers investment methodology of buying ‘attractive’ shares to benefit from an anticipated rise in their price. An additional short portfolio serves as a hedge against market declines are able to achieve a high but also provides an opportunity for managers to generate another source of alpha by selecting stocks more likely to underperform the broader market. Academic research1 upside participation with a shows that far fewer resources are applied to researching overvalued stocks compared to undervalued ones, implying that greater alpha potential can be generated from short much lower correlation to selling. Having two separate sources of alpha therefore not only allows long/short managers to create additional value for their investors, but also places significantly less bear markets emphasis on beta in determining the success of the strategy. Consequently, equity long/short managers are able to generate investment returns with extremely attractive dynamics – a high participation in the upside potential of stock markets combined with a much lower correlation to equities during bear phases. The concept of short selling In 2008, the practice of short selling attracted much adverse comment as politicians and other public figureheads sought to apportion the blame for sharp falls in share prices across the financial sector globally. As the credit crisis heightened, in spite of a blanket ban in the short selling of financial stocks, it became widely recognised that ‘shorting’ was a natural reaction to toxic balance sheets rather than a fundamental cause of the market stress. In his Nobel Laureate address in 1990, William F Sharpe, one of the originators of the Capital Asset Pricing Model, referred to the ‘societal’ advantages of shorting. He stated that its exclusion would result in “a diminution in the efficiency with which risk can be allocated in an economy’” potentially leading to lower overall welfare. The problems associated with a one-sided market are effectively exacerbated by the use of leverage (borrowing money to buy stock), while shorting (borrowing stock to sell) is the obvious counterbalance. In addition, shorting increases the depth of the market, thereby reducing the spread, or transaction cost, incurred by market participants. Numerous pieces of academic research confirm that market quality (i.e. greater liquidity with less volatility) is enhanced by short selling activity. Indeed, in commenting on the impact of short selling restrictions in December 2008, Professor Charles Jones, Chair of the Finance and Economics Division at Columbia University, stated “virtually every piece of empirical evidence in every article ever published in finance concludes that without short sellers, prices are wrong”. The ability to sell short therefore also promotes efficient price discovery because it allows markets to incorporate grounds for pessimism in share prices. This results in more accurate pricing of securities and helps to prevent misallocation of capital in the economy. 1. Source: ‘Profit from both winners and losers’ Jacobs and Levy. 7/12
  8. 8. UCITS Portfolio construction and metrics In addition to the traditional and intuitive role of security selection, there are three factors which will determine the relative success of any long/short strategy: 1. effective management of gross/net exposures 2. leverage 3. long/short ratio The gross market exposure is the sum of the absolute value of the long and the short positions and illustrates the extent to which (if at all) leverage is applied, while the net market exposure is equivalent to long market exposure less short market exposure. The equity long/short approach allows the systematic (or market) risk to be actively The equity long/short controlled through the management of gross and net exposures. In reviewing past exposures, research shows that hedge fund managers gradually increased both net approach allows for and gross exposures from the first quarter of 2003 until the second quarter of 2007 in order to capitalise on the increasing opportunities they were able to identify and to systematic risk to be benefit from a lower level of overall market volatility. Having peaked at the end of the second quarter, levels began to decline in advance of the sub-prime affliction as actively controlled managers re-evaluated their exposures in light of escalating risk. However, it is important to consider that most equity long/short managers are not primarily focused on trying to determine market direction, but rather amend their exposures as a by-product of prudent management. Unlike their long-only counterparts, long/short managers invest only where they see attractive risk-adjusted opportunities and are able to exclude certain positions when market conditions are unfavourable. Active management of gross/net exposures 80 % 2.4 2.2 60 % 2.0 1.8 1.6 40 % 1.4 1.2 Gross exposure Net exposure 20 % 1.0 0.8 0% 0.6 Jan 07 May 07 Sep 07 Jan 08 May 08 Sep 08 Jan 09 May 09 Net exposure Gross Exposure The above chart examines how the underlying managers in a fund-of-funds portfolio (Man Equity Hedged Strategies) were able to adjust their exposures from the peak of the 2003-07 bull market through the credit crisis and beyond and create value for their Source: Man database. 8/12
  9. 9. UCITS investors. This clearly demonstrates that the ability of long/short managers to dial-up or dial-down their exposures, in accordance with active portfolio construction and sound risk management, can provide proportionate participation on the upside and greater insulation on the downside. The data in the table below can be used to help illustrate the potential influences of leverage and the long/short ratio. 2. Long-short equity 3. Long-short equity Exposure 1. Long-only equity (Levered) (Unlevered) Capture index returns Objective Generate consistent returns Generate consistent returns + some alpha Alpha generation Long -only positions Long + short positions Long + short positions Long 100 % 130 % 70 % ( balance in cash) (Short) (0 %) (80 %) (30 %) Gross exposure 100 % 210 % 100 % Net exposure 100 % 50 % 40 % Long/short ratio n/a N/A 1.6 2.3 The term leverage (or ‘levered’) can be applied to any fund with gross market exposures of more than 100%. This is the case for some of the more active equity strategies pursued in the traditional asset management arena, such as 130/30 funds, which use the proceeds of short selling stocks to the value of 30% of total assets to proportionately increase their long exposure and potential returns. Another measure of relative exposures is referred to as the long/short ratio, which is expressed as the long exposure divided by the short exposure. The significance of the The judicious application long/short ratio is that it will help to determine the balance between downside and upside participation. of moderate leverage Using the statistical data in the table shown above, assuming that the stock market falls can enhance returns by 15% and each manager adds the same proportionate value through stock selection , 1 the following scenarios would play out: fund 1 would achieve an investment return of -10% fund 2 would return +3% fund 3 would return -1% Consequently, despite appearing more leveraged and directionally focused than fund 3, fund 2 would achieve the best results in this scenario. Consequently, the conclusions that can be drawn from this example are twofold; the judicious application of moderate leverage can enhance portfolio returns, while the long/short ratio, in conjunction with gross/net exposures, constitute important aspects for investors to consider. 1. Value added stock selection assumptions: long positions return -10%, short positions return -20%, market returns -15%. 9/12
  10. 10. UCITS Equity long/short managers also offer attractive liquidity terms in comparison to most Equity long/short provides other enhanced-alpha strategies, although complexities in the execution of these disciplines make it difficult to meet investor expectations of daily subscriptions/ attractive liquidity terms redemptions. In particular, the short sale of borrowed securities involves depositing collateral with a prime broker, while daily marking-to-market can result in margin calls. compared to most other As such, the administrative burden makes it both difficult and potentially costly to reverse a number of short positions simultaneously. A spate of unexpected enhanced-alpha strategies redemptions could be met by simply liquidating long positions but this would unsettle the balance of gross and net exposures. Similarly, holding a cash reserve to ensure daily liquidity would dilute investment performance. Consequently, equity long/short seeks to balance the needs of investors by providing favourable liquidity terms without compromising investment returns. Implementing equity substitution In general, and over time, the majority of equity long/short managers tend to carry a slight net-long bias within their portfolios. However, there are many different approaches within the long/short spectrum. Key dynamics of active long/short equity strategies Market Market Investment Style Geographic Industry focus Time horizon exposure capitalisation approach ▲ Net long ▲ Value ▲ Small ▲ Global ▲ Fundamental ▲ Sector specialist ▲ Short term ▲ Market ▲ Growth ▲ Mid ▲ Regional ▲ Macro ▲ Generalist ▲ Medium term neutral ▲ Momentum ▲ Large ▲ Country ▲ Thematic ▲ Long term ▲ Net short specific ▲ Agnostic ▲ Technical ▲ Variable ▲ Quantitative ▲ Activist ▲ Short selling Source: Adapted from AIMA Canada’s strategy paper: ‘Long/Short Equity’ by Colin Stewart, CFA, and Keith Tomlinson, CFA. As can be seen from the table above, the breadth of the universe creates an ideal critical mass from which fund of hedge fund managers can seek to blend disciplines with complementary characteristics in order to optimise risk-adjusted returns. As part of the research process, fund of hedge fund managers look for a competitive edge (i.e. some unique skill, such as superior analytics or opportunistic trading which is evident in the execution of the discipline and can be repeated in the future) when selecting disciplines for inclusion in their portfolios. 10/12
  11. 11. UCITS Where investors decide to make direct investments in the long/short arena, it is important to bear in mind that diversification is key. The presence of ‘outliers’ in the return distributions found in the equity long/short arena means that injudicious manager selection should be avoided. Consequently, it is essential that investors look for proven short-selling expertise, a credible performance track record and sound risk management before committing assets. Conclusion The equity long/short approach gives investors access to two separate sources of alpha and flexible beta, which can collectively create attractive, asymmetric returns. The impact of alpha is frequently magnified in long/short disciplines as compared to long-only portfolios, as it normally stems from both the long and short side of the portfolio. In addition, as equity long/short is much less concerned with index weightings and other portfolio constraints, manager conviction and skill can play a significantly greater role. Relative to other hedge fund strategies which offer attractive risk-adjusted returns, the equity long/short approach is also liquid and transparent. The ability of equity long/short strategies to protect capital in prolonged bear markets Experienced fund of hedge makes market timing much less of an issue for investors determining strategic asset allocation decisions. The Pyramis Pulse European Pension Insights Survey, published fund managers can add in December 2009, highlighted a common issue for trustees; exposure to various asset classes has become misaligned with strategic targets because of exceptional volatility value through rigorous and returns. Some respondents stated that they were substantially underweight equities. This reflects a failure to increase equity exposure to compensate for the slump manager selection in the value of their equity portfolios in 2008 and early 2009. As a consequence, the strength of the subsequent rebound has exaggerated the misalignment of asset weightings. Conversely, a similar proportion of respondents highlighted their need to manage equity exposure lower in order to rebalance risk budgets. Both of these groups could benefit from the implementation of an equity substitution strategy. There are singular risks associated with equity long/short investing. Consequently, experienced fund of hedge fund managers can add significant value through rigorous manager selection, as well as easing the administrative burden on behalf of their investors. The risk of fund attrition is also mitigated in a portfolio context. In summary, the main attributes of equity long/short disciplines are as follows: they can generate a superior, asymmetric return profile in comparison to long-only investment; they can insulate investors from the implications of large drawdowns; and relative to most other enhanced-alpha strategies, they are liquid, transparent and intuitive. A well-constructed portfolio of alpha-generating equity long/short managers should continue to produce enhanced risk-adjusted returns in comparison to any relevant equity index or long-only disciplines over a normal market cycle. Such portfolios constitute a compelling form of equity substitution and can add significant value in enhancing the efficiency of a broader equity allocation. 11/12
  12. 12. UCITS Important information This material is communicated by Man Investments Limited, which is authorised and regulated by the Financial Services Authority. Man Investments Limited and/or any of its affiliates may have an investment in the product mentioned in this material. Any organisations or products described in this material are mentioned for reference purposes only. Information contained herein is provided from the Man Investments' database except where otherwise stated. Potential investors should note that alternative investments can involve significant risks and the value of an investment may go down as well as up. There is no guarantee of trading performance and past performance is not a reliable indicator of current or future performance. Returns may increase or decrease as a result of currency fluctuations. This material is for information purposes only and does not constitute a recommendation or solicitation of any kind. This material is proprietary information of Man Investments Limited and its affiliates and may not be reproduced or otherwise disseminated in whole or in part without prior consent from Man Investments Limited. This material is intended only for investment professionals and professional clients and must not be relied upon by any other persons. 12/12