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Long/Short Equity – Does Skill Still Matter?

Wellington Management – Equity long/short funds: Are the good times gone or does skill still matter?, January 2017

  • Since the GFC, world has been awash in liquidity
  • Prolonged and unprecedented use of monetary stimulus has stabilized growth, returned major developed markets to full employment, and allowed consumers and companies to repair balance sheets
    • It has been the era of the “Great Beta Reflation Trade”
  • Over this same period, hedge funds generally, have lost some of their luster; performance broadly has been disappointing and caused investors to rethink the potential benefits relative to the fees they pay

Breaking Down Past Performance

  • Recent performance of long/short equity funds into context, both historically and relative to a broad equity beta, in this case S&P 500
    • Additionally, created a custom universe of equity long/short managers within the HFRI Equity Hedge Fund Index with the simple requirement of having at least 20-year track record, regardless of style or investment focus
    • There are nearly 60 such managers, from which we then chose the top quartile over the 20-year period (Top-Quartile Composite)

comparison

  • Few observations from the underlying custom universe:
    • In the 5 years ended September 2001, nearly half of the TQC managers were below the universe median and four of those managers trailed the S&P 500
    • 1/3 of the TQC managers were below the universe median for the 5 years ended September 2016
    • Despite the TQC beating the S&P 500 handily over the full 20-year period and the majority of that group beating the index in 3 of the 5-year periods, only one TQC manager beat the S&P 500 during the latest 5-year period
  • Even the top-performing and most battle-tested managers go through difficult times

What’s Driving Underperformance and What Could Change?

  • While some managers have simply not met expectations, we think this disappointing period can also be attributed in large part to a confluence of macro and market forces, a number of which we believe are more cyclical than secular
  • Global monetary policy: since the GFC, have been in uncharted territory with global monetary policy; more recently, some have entered the bizarre world of negative interest rates
    • Yields of US, German, and Japanese debt sit at or near all-time lows, which means their returns have peaked along with equities
    • Arguably, hedged strategies are not designed to keep pace in a world where pure beta is the best trade
  • Low-beta behavior post-GFC: median net leverage for US equity long/short equity managers going into the GFC was roughly 75%; in September 2016, sat at just over 45% and since mid-2009 it has mostly been in a range between 40% and 60%
    • Trend toward lower net exposure comes from a behavioral shift post-GFC, with managers seeking to better preserve capital on the downside
    • As equity markets have continued to climb, the result of this focus on downside mitigation has been a widening performance deficit for long/short community relative to traditional equities, even on a risk-adjusted basis
  • Migration from active to passive: from January 2015 to September 2016, about $350Bn flowed out of active equity mutual funds and roughly $500Bn flowed into passive equity vehicles
    • Technical selling pressure has been a persistent headwind to many attractive investment opportunities, including companies whose fundamental worth may be distorted simply by the imbalance of flows
    • Ultimately, it should be a positive set-up for active managers and hedge funds as we expect there to be less active and unconstrained money chasing potentially attractive investment ideas
  • Hedge fund industry growth/manager saturation: hedge fund assets have grown by more than 20% annually on average since 1990 and today sit at nearly $3 trillion
    • Markets have grown during this period but their growth has not kept pace with that of the hedge fund industry – hedge funds are competing for fewer opportunities
    • Industry has shifted to a behemoth where there is greater balance between winners and losers – simply put, finding those managers with persistent skill has become more difficult

Looking Forward

  • Dispersion is the lifeblood of equity long/short strategies and it has been cyclically low since markets stabilized following the GFC
  • We expect the Great Beta Reflation Trade to recede – at that point, market dispersion should rise and it should become relevant again to distinguish the good from the bad
  • Believe that strategies with the flexibility and the skill to exploit opportunities in both up and down markets will play an increasingly important role in portfolios

Manager Skill: What to Look For

  • Track Record
  • Organizational Stability
  • Stability of Process
  • Clear Expectations, Net of Fees
  • Willingness to Close – when capacity limits are reached, managers should be willing to close or even return capital to investors
  • Trust
Image Source: Investment Company Institute, Simfund, Credit Suisse
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