EQIRA: Empirical and Quantitative Investment Research and Analysis

Why Do Investors Still Favor Long/Short Equity?

In its recent Investor Outlook, Preqin included the following chart describing investor preferences in the hedge fund space. It shows that more than half of the allocators interviewed intend to seek out new or additional long/short equity managers in the next 12 months.

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Long/short equity is, by far, the most desired strategy. But why?

As we noted in our Strategy Spotlight earlier this week, equity long/short performance has been lackluster for more than a decade now. Consider the following:

Returns Have Trailed Off Significantly Over the Last Several Years

Since late 1989, equity long/short hedge funds have generated a compound annual return of 11.5%. They excelled during the 1990s, with returns for the decade reaching 20.1% per annum. Since the start of 2000, however, mean returns have lagged, declining to 6.3% annually. Outside of 2013’s 15.9% return, the strategy has produced single digit positive or negative returns in every year since 2010. In fact, its risk-adjusted returns have been comparable to those of a 60/40 portfolio since the end of the 2000-2002 bear market.

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Note: In a growth to $1 chart, the lower the line at any point in time, the better the return from that point forward. So this second chart is telling us that equity long/short performed significantly better on a risk-adjusted basis from 1990 until about 2000, but has only been moderately better than global equity and global 60/40 since.

Assets Under Management Have Grown Significantly

According to BarclayHedge, the collective assets under management by equity long/short funds is currently more than six times what it was at the end of 1999 and 14 times what it was at the end of 1997. The outstanding returns in the early-to-mid-1990s were earned by a disproportionally small group of investors.

If you believe that the total alpha available in equity markets is a roughly fixed percentage of total market capitalization, then the significant increase in AUM substantially dilutes the amount of alpha available per dollar invested.

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Despite a Recent Uptick, Alpha Has Been Negligible

Since the end of the early 2000s bear market, alpha relative to traditional assets has been hovering near zero.

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According to our more comprehensive multi-factor model, the strategy’s return from alpha has been 8.74% over the last 10 years. Total. Not annually. That equates to 0.84% per annum.

Correlations to Traditional Assets Have Been High

Correlations with global equities and a global 60/40 portfolio have risen from around 0.5 in the early 1990s to approximately 0.9 today.

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Long/Short Provides Little Tail Diversification

Long/short tends to do its worst at the same time all your other assets are blowing up. Its tail risk is highly correlated with those of: US equities, short volatility strategies, inflation-linked bond spreads, emerging market bonds, investment grade and high yield credit spreads, commodities, and emerging market currencies.

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…and Little Diversification, In General

The strategy has a long-term beta relative to global equities of 0.4, and that beta has only risen in recent years. It makes the strategy highly sensitive to broad market performance. According to our factor attribution analysis, more than 45% of the strategy’s return over the past 10 years came from beta.

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94% of its Risk Has Come from Passive Sources

US equity beta has driven 60% of the strategy’s total risk over the past 10 years. Foreign equity beta added another 13%. Equity size, sector beta, and value together added an additional 13%. All combined, risk sources that investors can obtain cheap, passive exposure to comprised 94% of its risk. Idiosyncratic factors (alpha) only represented 5%.

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Wrapping Up

Preqin, in the same report, includes this chart describing investors’ main reasons for investing in hedge funds and private equity.

preqin_investment_motivations

They indicate that investors choose hedge funds for diversification, low correlation to other asset classes, and portfolio volatility reduction. Considering that long/short equity accomplishes these goals far less successfully than other hedge fund strategies, however, there appears to be a major disconnect between investor goals and allocation intentions.

Investors seem to like equity long/short because it’s been around for a long time, is widely accepted and is easy to understand, but perhaps it’s those same qualities that have made the average long/short fund such a dud. Although allocators may be able to identify above-average managers with persistent alpha, wouldn’t it be easier to prioritize strategies without such a significant headwind?

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