Twenty years ago, it was index matching. Fifteen years, ago it was international investing; 10 years ago, derivative instruments.
When we first heard about these investment innovations, they sounded complicated. Some investors questioned their prudence. Indexing and international were labeled "un-American."
Today's big, new idea is long/short active equity management. As Yogi Berra said, "It's deja vu all over again." Investors have been slow to embrace new ideas, yet some of the best rewards were earned by early users.
During the four years since long/short, market-neutral equity portfolios were introduced to institutional investors in 1989, assets committed to this approach have grown rapidly. Many major tax-free investors now use long/short portfolios, including at least one who now only hires equity managers that use such portfolios.
Strategy vs. construction
Use of long/short portfolios unbundles active return from market exposure and expands the potential profit derived from a manager's insight. It is not a strategy that will get "used up."
Value investing is a strategy. Low p/e investing is a strategy. Long/short investing is not; it is a portfolio construction technique. Because of this misconception, the potential value of long/short investing has been underestimated and a powerful new tool is being underused.
An equity investment strategy defines the kind of stocks an investor finds attractive. It specifies, explicitly or implicitly, the desirable investment characteristics an investor hopes will dominate the portfolio. A growth strategy, for example, might be expressed as a plan to buy stocks with estimated earnings growth over 15% where current quarterly earnings reports exceed stock analysts' estimates.
A portfolio construction technique, on the other hand, defines how an investor will create a package of specific investments with the appropriate level of risk and expected extra return. Long positions, short positions, net market exposure, equal weighting, capitalization weighting, industry weights, factor exposures - these are structural decisions that all managers, regardless of strategy, must address.
Moreover, portfolio construction parameters might have as much or more to do with investment results as a manager's ability to select stocks. As Richard Michaud said in a recent article in the Financial Analysts Journal, "The long-only efficient frontier is dominated by the long-short efficient frontier in the sense that, at any given level of residual risk, the long-short portfolio will never have less alpha, or a smaller gamma (return-to-risk ratio) than the long efficient portfolios."
Any equity manager could use long/short portfolios to extract more expected extra return per unit of risk from a strategy. A growth stock manager can buy companies whose earnings are accelerating while shorting companies whose growth rate is declining. A value manager can own low p/e stocks while shorting high p/e stocks. Consequently, we should expect just as much diversity of returns from managers of long/short portfolios as we get from managers of traditional long portfolios. They will not all have good and bad years simultaneously. They will not all have the same volatility, even if they are all market neutral (see Table 1). They will not all have the same return. The hard-learned lessons about the value of diversifying manager styles in a multimanager mix should be remembered when planning the use, and assessing the results, of long/short equity investing.
It's not a hedge fund
Recently a so-called "market neutral" manager of collateralized mortgage obligations made headlines because of some very large losses. Most market neutral managers will escape the fate because typical long/short stock portfolios have vastly lower risk. There are some major differences between this particular hedge fund manager and the typical long/short manager.
This hedge fund, like most, borrowed money to amplify its bets. Typical long/short stock strategies do not use leverage.
CMOs have a complex relationship to interest rates. A CMO can rise with a small decline in interest rates, but fall with a large decline in interest rates. This makes hedging difficult. Stocks do not exhibit this characteristic. A stock's tendency to rise or fall with the market does not usually reverse as a function of the magnitude of the market move.
CMOs are highly specialized with few natural buyers and sellers. There can be large bid/ask spreads, particularly when interest rates are chaotic. Stocks, even during the October 1987 crash, had much more liquidity than CMOs have had recently.
Neither the use of leverage nor investing in CMOs is required in the management of a long/short portfolio. The risk return profile of each long/short manager is unique. It is a function of the manager's strategy, specific holdings and risk controls.
How does it work?
According to "The Law of Conservation of Value," stock valuation is a zero-sum game in which the total dollars of overvaluation must equal the total dollars of undervaluation. In other words, stocks, on average, are "fairly" priced; for every stock that is undervalued, there must be a stock that is overvalued. Consequently, opportunities on the long side.
Active investment managers explicitly or implicitly rank stocks from the most undervalued to the most overvalued. They build their portfolios by buying the best and ignoring the rest. Rather than just avoid overvalued stocks, why not tap their profit potential with a long/short portfolio of "hedged trades"? The typical short-seller borrows stock, sells it and hopes to profit by repurchasing it later at a lower price. Hedged trades, by contrast, can be profitable even if the price of the shorted stock rises. A hedged trade, is a pair of investments, one long and one short, where the risk of the market is neutralized and the return is equal to the performance difference between the long and short positions plus interest rebate. Within the context of a long/short portfolio, a stock that underperforms the market by 5% is just as profitable as owning one that outperforms by 5%.
The riskiest part of an investment in stocks is the stock market itself. The skill of even the best investment manager is overwhelmed by the rise and fall of the market. More than 90% of a typical portfolio's return, long or short, is due to movement of the overall market, while less than 10% is due to the manager's skill. Moreover, a manager's stock-picking skill is sometimes swamped by unintended industry bets. A carefully constructed and maintained hedged portfolio is simultaneously long the market exposure (beta +1) and short the market exposure (beta -1). The resulting portfolio is market-neutral or zero beta. Further risk reduction can be achieved by taking equal dollar long and short positions within each industry, thus making the portfolio industry-neutral.
Because the long/short portfolio is market neutral, the return equals the manager's alpha on the long portfolio, plus the alpha on the short portfolio, plus the interest rebate. The portfolio does not earn the long term equity risk premium because it is not exposed to market risk. If the manager has skill, the long/short portfolio should provide consistently good returns in both up and down markets. Market return and risk, if desired, can be reintroduced to the aggregate portfolio through the use of stock index futures (See Table 2).
Long/short equity investing is a triumph of new thinking applied to old concepts.
The result is an efficient tool appropriate for institutional equity portfolios and conservative individual investors.
