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The Real Deal: Long/Short Equity Trusted Alternatives. Intelligent Investing.SM Managed Futures Commentary The Real Deal: Long/Short Equity May 2010 In ThIs PaPer This paper addresses Long/Short Equity in its purest form, which we define as a long equity portfolio that is offset, or hedged, by a short equity portfolio. This hedge typically is achieved via individual equity positions, which can be augmented with index shorts and/or options. The value of the short portfolio is two-fold. First, it provides a hedge. Second, it may also provide an incremental alpha opportunity as managers seek to profit from shorting stocks that underperform the market. True Long/Short Equity funds typically are net long, but have the ability to adjust the net exposure as markets shift, thereby potentially producing alpha, which is defined as the excess return beyond the benchmark. The manager may also choose to keep a portion of the portfolio in cash, should the prevailing markets warrant caution. the strategy to participate on the upside in » Key Point» A TRuLy HEDgED FunD “A look at the history nvestors poured more than $7 billion into rising equity markets while protecting capital in of Long/Short Equity Long/Short Equity hedge funds in the latter adverse market conditions. hedge funds shows that they have consistently Ihalf of 2009—more assets than any other outperformed long-only hedge fund strategy.† Managers took advantage What iS A Long/SHort HEDgE equity exposure and of the rising equity markets to increase their net FunD? have done so with less exposures and produced gains on the long side Given the amount and range of media coverage risk.“ in 2009. The strategy rewarded investors with dedicated to hedge funds today, let’s step back a 24.6% gain for the year, beating the overall and define what a hedge fund is, and then get returns of 20.0% for the hedge fund industry to the matter of specifically defining a true as a whole in 2009.‡ Long/Short Equity hedge fund, along with its historical and ongoing role in a portfolio. What attracts investors to Long/Short Equity hedge funds is their tendency to exhibit a There likely are as many definitions of strong absolute return performance profile hedge funds as there are people you can across a broad array of market conditions. ask for a definition of a hedge fund. For our purposes, hedge funds are private investment † Source: Credit Suisse/ A look at the history of Long/Short Equity partnerships in which the manager of the fund Tremont hedge funds shows that they have consistently is able to trade in a variety of global markets, ‡Source: Hedge Fund outperformed long-only equity exposure and with the ability to be long and/or short, using Research, Inc.) have done so with less risk. The ability to shift both cash and leveraged positions. Typically, exposure in changing market conditions allows the manager has a significant personal stake PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. There is no guarantee that any investment product will achieve its objectives, generate profits or avoid losses. See Impor- tant Risk Disclosures at the end of this document. ©2010 Altegris Investments Altegris Research Commentary Trusted Alternatives. Intelligent Investing.SM in the fund, which aligns the incentives of the Alfred Winslow Jones’ Long/Short model (see manager with those of investors in the fund. sidebar below). Long/Short Equity had many advantages as a strategy, not the least of which KEy DRivERS oF gRoWTH was that it was relatively straightforward and One industry insider speculates that in the easy to understand from an investor’s point of 1970s there were no more than 30 hedge funds view. The instruments were publicly traded with the largest having approximately $50 and the terminology—large-, mid- and small- million under management. The 1980s saw the cap, value and growth—addressed concepts scions of the industry introducing their funds, with which investors were already familiar. including George Soros, Michael Steinhardt Other advantages came in the form of liquidity and Julian Robertson. Access to hedge funds and capacity. In addition, Long/Short Equity was largely limited and the bulk of the assets managers had advantages not available to their under management came from high-net-worth long-only brethren—namely the ability to go investors, with only a smattering of more short or go to cash if the market conditions progressive endowments and foundations were unfavorable. investing. Hedge funds were strictly a “cocktail industry” and not yet institutionalized. According to Hedge Fund Research, Inc., in Investment decisions depended largely upon 1990, the hedge fund industry had assets personal recommendations and introductions. under management of $38.9 billion, climbing to $456.4 billion by the close of 1999. Pension The 1990s was the decade in which hedge fund funds and endowments were increasingly » Key Point» investing began to flourish, particularly the entering the fold, including large respected Long/Short Equity model. Many equity traders institutions such as the California Public “In just one decade, hedge funds had grown left their institutional desks to start hedge Employees’ Retirement System (“CalPERS”), from an “exclusive funds for the increased flexibility in trading Harvard and Yale. In just one decade, hedge club” industry to an style. In his book Absolute Returns: The Risk and funds had grown from an “exclusive club” asset class, with Long/ Opportunities of Hedge Fund Investing, Alexander industry to an asset class, with Long/Short Short Equity funds representing more than Ineichen notes that by 2001, more than 50% of Equity funds representing more than half of half of assets under the existing hedge funds were a variant of the assets under management. management.” The Jones’ Move To The InvestmenT neIghborhood Alfred Winslow Jones is widely credited with creating the first “hedged fund” in 1949. That same Long/Short Equity fund exists today, which is a testament to the strategy’s endurance. Prior to founding his eponymously named financial firm, Jones was a reporter and editor for Fortune magazine. Jones penned an article for Fortune entitled “Fashions in Forecasting” that sparked the ideas for the first “hedged” fund. Fascinated by the technical analysis which market forecasters were using, Jones strongly doubted their abilities to consistently predict market direction. This led him to think about how to take advantage of gains in the market, while cushioning the blow of downward swings. His thought process resulted in the development of the model for the original Long/Short Equity fund. Jones consistently stressed that his was a “hedged fund” and not just a “hedge fund,” pointing out that the most important characteristic of it was that the fund must be hedged. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. There is no guarantee that any investment product will achieve its objectives, generate profits or avoid losses. See Impor- 2 tant Risk Disclosures at the end of this document. ©2010 Altegris Investments Altegris Research Commentary Trusted Alternatives. Intelligent Investing.SM THE AnatoMy oF Long SHort with company management teams, suppliers, Long/Short Equity hedge funds have comprised and/or customers, as well as a more subjective the lion’s share of hedge fund assets since or innate ability by the manager to evaluate 1949. What drives these funds’ longevity is the market dynamics. Common metrics used combination of effective stock selection and to compare stocks include valuation ratios, managing market exposure. The strength of a such as price-to-earnings, efficiency ratios Long/Short Equity hedge fund comes from two such as return-on-equity, and leverage ratios factors. One, its manager’s success in picking such as debt-to-equity. Managers may invest stocks on both the long and the short sides. in specific sectors (e.g., energy, consumer, Two, adjusting net market exposure up or down financial services, technology); geographic as appropriate to market conditions. Let’s look regions (e.g., Asia, emerging markets, G7); at this in more detail. and/or styles (value or growth). While similar factors are frequently analyzed on the long and 1. Stock Selection short side, there is a definite art involved in First and foremost, the manager’s ability to pick short stock selection that cannot be attributed stocks is a critical component of these funds to metrics alone. and a core element in their ability to generate alpha. This is an important aspect in which 2. Managing Market Exposure Long/Short managers differentiate themselves The second component of Long/Short Equity from traditional long-only funds, for they must funds is the ability to manage market exposure. pick stocks on both the long and short sides A Long/Short Equity fund will adjust its long/ and simultaneously understand and manage short exposure to changing market conditions » Key Point» “What drives Long/ the delicate balance between them. Selecting over time. Higher net long exposures (long Short Equity funds’ stocks is a fundamental, research-driven exposure minus short exposure) will generally longevity is the combi- process for both long and short portfolios. The correspond with periods of increased nation of effective stock process can vary from manager to manager, bullishness, while lower net exposures would selection and managing market exposure.” but typically will involve some combination typically indicate a more bearish outlook and/ of financial statement analysis, conversations or cautious positioning (See Figure 1). Figure120% 1: Exposure Management FoR iLLustrativE PuRPoSES onLy 100% 80% 60% 40% 20% 0% -20% -40% 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Long Net Short PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. There is no guarantee that any investment product will achieve its objectives, generate profits or avoid losses.
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