The use of factor analysis by hedge funds and funds of funds is generally a common tool for analyzing portfolio exposures. However, now investors are applying the same tool in asset allocation analysis. The result is a consideration of long-short equity as a part of long-only equity during investment portfolio construction. Moving beyond 130/30 equity strategies to below 100% net long exposures is a natural extension that seeks to reduce portfolio volatility. This trend could have an enormous impact on the flow of assets to long-short equity managers because long-only U.S. equity remains the largest institutional asset class.
The ability of U.S. ERISA pension plans to withstand portfolio fluctuations is declining as they consider the full implementation of Financial Accounting Statement 158, which is expected to cause an impact on corporate income statements from annual changes in pension assets. The effect of this accounting standard might place additional pressure on pensions to de-risk their portfolios, especially now that funded statuses have improved for many plans. One way to accomplish this is through the reduction of volatility in equity allocations. A chief benefit from long-short equity hedge funds is their ability to accomplish a beta exposure to the equity market, but one that is less than 1.0 and therefore hedged against the full volatility of the market. The long-term goal of long-short equity is to emulate the return from the equity market but to accomplish this with less volatility because of its less than 1.0 net exposure (gross longs minus gross shorts).
There are several ways to accomplish a desired outcome of reducing equity asset class volatility while still maintaining its relatively high expected return. One way to accomplish this is through dynamic hedging using derivatives to reduce the impact from short-term swings in the market. This could be accomplished through a form of tactical asset overlay, either by using a direct options program or a tactical asset allocation overlay manager. Another possible solution is through an allocation to active managers who can modify their inherent passive market exposure.
Although market-neutral equity managers have been employed for many years, either on a stand-alone basis or in portable alpha programs, the notion of using other gradations of beta-exposed managers has not been widely adopted by investors. Most investors expect their active equity asset allocation to be implemented by managers who are 100% net long with no short exposure. Meanwhile, long-short hedge funds (either direct hedge funds or funds of funds) often reside in an absolute-return category with a benchmark that might be more market-neutral oriented than equity-market linked.
A better fit for this allocation would be to place hedge fund managers that evidence equity market beta into the traditional equity asset class allocation. Once done, then an investor can use active equity managers with betas of less than 1.0 as a tool to tilt asset class allocations. Moreover, a reduction in beta exposure does not imply a reduction in expected total return. The idiosyncratic return that active equity managers are capable of generating expands into new sources when greater types of managers are added to a portfolio. For example, long-short equity managers may find short sale investment opportunities as well as long investment opportunities.
A final way to moderate beta exposure of an equity asset class allocation is to invest in long-only equity managers who are able to build more concentrated portfolios with fewer stocks. This can be done in active management, however, many investors shy away from these managers as being too risky or as violating asset class purity if they move a portion of their portfolios to cash. Another way to view these managers is as a form of low-fee hedge funds that use cash positions rather than short positions to moderate equity market beta exposure. One sensible approach would be for an investor to consider a portfolio of all types of these moderated-beta managers, rather than excluding some very good alpha generators because they do not neatly fit within preconceived asset allocation notions. When viewed from a portfolio approach, managers with less than 100% net long exposures can offer attractive benefits, rather than viewing them in isolation from a risk-and-return perspective.
The approach to equity through dynamic beta exposure among active managers might be a more effective application of asset allocation than the alternative, which might be to reduce an equity allocation by removing assets and shifting them to another area (e.g., fixed income). Indeed, the use of active equity managers that have reduced beta exposures effectively delegates some tactical asset allocation to the active managers. Presumably, the managers would increase their net exposures (a proxy on beta) when investment opportunities were bountiful and reduce them when attractive investments were scarce.
This approach to an investors equity asset allocation increases the types of managers that can be used; it fully uses the benefit of quantitative tools that are available to measure beta-factor exposures; it is applicable to other asset classes using beta-factor analysis; it helps to shed new light on the complaint that hedge funds possess too much beta; and it further improves an investors chances of accomplishing what is sought from the use of alterative investments in traditional portfolios, which is diversification, volatility reduction and performance enhancement.
The views in this article do not necessarily represent the views of Lehman Brothers Inc. and its affiliates. The article is for information purposes and should not be considered investment advice or a recommendation for a particular investment strategy from Lehman Brothers Inc. or any of its affiliates. Historical trends discussed are not meant to imply, forecast or guarantee the returns of any investment.