Managing Equity Risk in Volatile Markets

In uncertain markets, investors often look to reduce risk and protect capital by selling equity assets. This, however, creates a conundrum as it takes the investor out of the market and introduces the probability that the investor may miss out on a potentially powerful rally, such as those we have historically seen following difficult market environments. This dilemma creates an opportunity for a strategy that will limit downside exposure while still retaining upside potential. Long/short equity strategies have provided that kind of return profile during the past 20 years through multiple market cycles.

With a long/short equity strategy, the manager is not limited to maintaining a long position or holding cash; rather, the manager can take short positions in securities that, based on his research, he believes will decline, creating more opportunities to generate returns while reducing risk in the portfolio. The investment manager typically uses a blend of publicly traded stocks and additional securities – such as options, futures and commodities – to achieve desired exposures to the overall market and/or specific sectors. In addition, long/short equity strategies are less constrained by pressures to closely track an equity benchmark than a long-only approach.

Long/short equity strategies have outperformed the S&P 500 – and have done so with lower volatility and lower maximum drawdown – since 1991.

A long/short equity strategy typically is pursued through hedge funds, because of the flexibility the structure allows, versus traditional long-only investment vehicles. Equity long/short hedge funds have the ability to go both long and short, utilize leverage and invest in a less constrained manner than most other investment vehicles. In fact, the strategy is the most prominent within the hedge fund industry. Generally, managers using this strategy have been successful in producing equity-like returns over a full market cycle with lower volatility and more downside protection than offered by long-only equity investments.

Long/short equity strategies, as represented by the Hedge Fund Research Inc. (HFRI) Equity Hedge Index, have outperformed the S&P 500 Index – and have done so with a lower volatility and lower maximum drawdown – since 1991, while also acting as a diversifier to a 100% equity portfolio.

The potentially lower volatility of long/short equity strategies compared to the overall equity market is an important factor for investors. Lower volatility enables investors to remain calm and stay the course. A panicked decision to withdraw after a market decline and leave cash on the sidelines may lead to realized losses and missed opportunities as markets recover.

“Recovering from a 50% drawdown can take significant time. You don’t want to be in a position to have to pull capital out of the market at an inopportune time,” said Anthony Zanolla, director of portfolio management for hedge fund investments at Northern Trust. “A strategy such as long/short equity, with lower volatility and lower maximum drawdowns, may make it easier for clients to sleep at night and remain invested for the long haul.”

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Long/Short vs. Long-Only

There are a number of important differences between long/short and long-only strategies that help explain the investment performance differential.

For example, a fully invested long-only equity index fund would have 100% long market exposure. A hedge fund manager, on the other hand, could be invested 60% long in the securities believed to be most undervalued and 40% short in those securities believed to be overvalued. This would leave the hedge fund manager with a 20% net long market exposure. As a result, more of the hedge fund’s performance is determined by the manager’s ability to identify undervalued and overvalued securities and less by the overall movement of the market.

Hedge funds also have the ability to use leverage during periods when opportunities appear plentiful. “Leverage does not always equate to increased risk. It can be a useful tool to reduce risk, as we often see in long/short equity portfolios,” Zanolla said.

In addition, the manager’s ability to short securities allows him to keep net market exposure at levels below that of traditional long-only funds. For example, a fund with $100 may be invested $100 long, $60 short. In this example, the fund’s manager is using leverage – borrowing $60 for total investments of $160 – but when we look at the fund’s net exposure, (the amount invested in long investments, less the amount in short investments) it is $40, or 40%. The result: more investments can bring more opportunities to make money, but the hedge fund’s lower exposure to the overall market typically results in lower volatility.

Another important difference for most long/short equity hedge funds is their opportunistic nature and their ability to focus on absolute, rather than relative, returns. Freed from the need to strictly adhere to benchmark characteristics, hedge fund managers can implement their investment views across a broader range of trades without deference to specific sector, country, or style allocations in an underlying benchmark.

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The Nuances of a Long/Short Strategy

There is wide variation in long/short equity strategies in terms of how each manager chooses to trade and invest. These differences can be geographic, sector-focused and style-oriented among others.

“Funds can be regional, focusing on areas such as Europe, Asia or emerging markets, or even more granular, focusing on China, India or other individual countries” Zanolla said. “Long/short equity funds also can concentrate on specific sectors, such as technology, health care or financials.”

The focus on geographies or sectors can be easily understood, but the differences in other strategic approaches may be less clear:

• Fundamental managers conduct traditional analysis of company valuations to find undervalued or overvalued companies.
• Quantitative managers tend to use statistics for evaluation of stocks and may profit from trades lasting only minutes.
• Emerging markets managers must navigate the unique risks of lesser developed markets to capitalize on less efficient pricing.
• Short-selling managers can be a diversifier to the portfolio and would be expected to profit from falling markets.
• Activist managers look for situations where they can influence the operations of a company and unlock value not recognized by the broader market.

The differences within long/short equity strategies are not manifested in the research process alone, but also in the way a manager constructs a trade. For example, when a manager has identified an attractive investment opportunity in an undervalued company, the manager could choose to implement the trade through the publicly traded stock or use the options on that same stock if that approach offered a more attractive risk-return profile to the portfolio.

Funds can be regional, focusing on areas such as Europe, Asia or emerging markets, or even more granular, focusing on China, India or other individual countries.

Long/short equity managers also have flexibility in how they isolate specific factors. If a manager had a long investment in an airline stock but did not have a view on the price of oil, the manager could calculate the necessary amount of oil futures to buy to hedge out this exposure and limit the risk.

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Why Long/Short Makes Sense

There are a number of reasons why investors might want to consider incorporating a long/short equity strategy in their equity allocations.

Some investors might want to find a way to smooth out returns, while others want to avoid substantial declines that could harm long-term return assumptions. Still other investors are attracted by the potential to lower the volatility of their equity allocations while retaining upside exposure. And, others are drawn by freedom from benchmarking and the flexibility to create customized portfolios to meet specific goals. Long/short equity strategy solutions can be crafted to complement any number of equity allocations. The solutions could be global, domestic or even targeted to specific market capitalizations or sectors. The range of investment options available to hedge fund managers enables a solution to even target specific volatility or correlations to existing portfolios.

For institutional investors, adding a long/short equity component to their equity allocation can enable them to reduce portfolio risk and reassess the ability of their portfolios to hold a larger allocation to equities versus an allocation to fixed income with lower expected returns. For investors who are underweight equity exposure, this strategy can be a way to increase exposure to equities, even in uncertain markets, while potentially taking on less volatility and drawdown risk.

Regardless of the reason for pursuing a long/short equity strategy, it is critical that an investor pursues a methodical approach to the implementation process. There are thousands of managers within the long/short equity universe and it can be exceedingly difficult for investors to assess their options for direct investment. It is also important to understand how any new investment alters the risk-return profile of the overall portfolio.

“In this environment, it is more important than ever to ensure that as an investor you are compensated for the risks you take, and that you use vehicles and strategies that are risk-aware and have the tools to manage that risk,” said David Williams, hedge fund product manager, Northern Trust.

Williams noted there is value to using a fund-of-funds structure to implement a long/short equity strategy. An investor gains the services of a professional team to handle sourcing and due diligence of potential managers, and the construction of a portfolio that combines desired exposures and appropriate risk controls. It is also typical to access a fund-of-funds with a lower minimum investment than it would take to invest individually with the managers in the fund-of-funds portfolio.

Hedge funds have been stereotyped as highly leveraged, high-risk investments, shooting for 20% annual returns, but this is not the case for the vast majority of hedge funds. In fact, the long/short equity strategies used by many hedge funds represent the potential of these vehicles to offer equity-like returns over a full market cycle with less volatility and more downside protection than long-only approaches.

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