For much of the past decade, investment profits have flowed to anyone who simply bought stocks and sat tight. But now the stock market is beginning to show signs of aging. Volatility is increasing, and many investors believe that a stock market decline may soon occur. And there is reason for concern.
The headwinds of rising interest rates, inflationary pressures, and the specter of trade war with China, conspired recently to trigger the first real correction in nearly three years. Since then, many investors are trying to execute better risk mitigation strategies to balance the need for returns against the desire for lower market risks. One possible solution: so-called long/short funds.
Long/short investment strategies have been used for decades by hedge funds, typically the domain of institutional and large investors, due to their ability to outperform the broader stock market through both up and down cycles with less volatility. In recent years, this sophisticated strategy has been made available to retail investors through mutual funds.
The headwinds of rising interest rates, inflationary pressures, and the trade war with China, conspired recently to trigger the first real correction in nearly three years - Learn how a long/short strategy can help Click To Tweet
How To Create A Solid Long/Short Investment Strategy?
Long/short equity is a stock-based strategy in which fund managers assume long and short positions with the flexibility to vary exposure to the equity market over market cycles. The strategy seeks to capture the upside of selected stocks and exploit the downside of others to generate higher risk-adjusted returns.
Generally, the manager purchases stocks with expected positive risk/return profiles, while stocks that are expected to decline in value due to deteriorating factors are shorted. A typical long/short portfolio might maintain a net long exposure of 50% to 125% with 0% to 35% of the fund’s assets held in a short position.
For example, the AMG FQ Long-Short Equity Fund Class I, which returned 8.12% in 2018 as compared to the S&P 500 which returned 3%, has a long-short equity position of 124% long equity and 19% short equity as of February 11, 2019.
The objective of a long/short strategy is to improve the potential for the overall risk-return portfolio while tamping down the kind of volatility we are now experiencing. While it may not outperform the indexes on the upside in any given year, it can minimize the downside, which can lead to outperformance over the long-term.
A long/short equity strategy can play an important role in portfolio risk management for three reasons:
Creates More Opportunities for Alpha
The ability to short stocks increases the fund manager’s opportunities to generate alpha without increasing risk. Rather than simply avoid overvalued stocks, managers can reap gains for the portfolio by selling them short. In addition, managers can use the short sale proceeds to take bigger long positions with the potential to increase portfolio returns. The use of leverage in these circumstances is constrained by regulations.
Provides Downside Protection
A fund’s short exposure can be used as a hedging function to balance long exposure by reducing market beta. When combined with the ability to adjust the cash level in their portfolio, fund managers can control both beta and volatility. During periods of high market volatility, managers can decrease their net long exposure, and increase it during periods of low volatility.
Can Improve a Portfolio’s Overall Return/Risk Ratio
Improving risk-adjusted returns generally means sacrificing returns. However, a long/short strategy implies a much more efficient use of risk capital than what can be achieved by a long-only strategy or a broad benchmark. Historical analysis shows that long-short strategies can achieve a higher level of risk-adjusted returns with half the volatility.
To be sure, by adding a long/short equity strategy to a portfolio as an asset class, it can cushion downside risk in challenging markets, while increasing return potential in rising markets, especially during periods of higher volatility. Because long/short is a stock-based strategy with low correlation to the overall stock market, investors can benefit from additional diversification while achieving equity-like returns with less volatility.