Perspektiven

Can long short funds offer a port in a stock market storm?

To say 2022 has been a difficult year for investors would be an understatement. What is particularly rare about this year is the fact that traditional diversification options haven’t worked. Diversifiers such as 60/40 equity/bond portfolios, defensive assets (such as consumer staples, real estate, utilities), new assets like cryptocurrencies and even gold have failed to protect investors from losses.

Something similar happened in the global financial crisis (GFC) in 2008, and again briefly in March 2020 when the global lockdowns led to a liquidity shock and meltdown in financial markets. This phenomenon typically only comes about in serious crises and thus is expected to be a very rare event.

The chart below, which is for the US, shows how rare it is for both equities and bonds to fall together.

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And the following chart gives an indication of how rare it is for 60/40 portfolios to suffer significant losses. The 2022 figure is annualised, which makes the year-to-date decline look more extreme.

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Rate rises from ultra-low base exacerbate market distortions

What is notable to us in this current sell-off in everything except the US dollar (even commodities are feeling the brunt of late), is how long the current dislocation in sovereign bond markets is lasting.

The drawdown in global government bonds is the largest in annualised terms since 1865, according to Bank of America, and can be directly attributed to the base level we are coming from due to Zero Interest Rate Policy (ZIRP). In the US during the GFC, the 60/40 US Index fell for nine months, but this was primarily the equity and corporate bond side. We are already seven months into the current drawdown with no let-up.

Alongside ZIRP, what is also different now compared to the GFC is that inflation is much higher. Central banks are draining liquidity, rather than flooding the markets with it as the quantitative easing experiment is, perhaps, drawing to a close. For this reason, it is difficult for us to assume that this challenge to the efficient market hypothesis (i.e. that asset prices reflect all available information) is over.

“Cash is king” is often a term bandied around in bear markets, and it is often true. The problem with this today is that the yield on cash after inflation is currently extremely negative and inflation has now reached high single digits in the western world.

Long short funds can offer minimal market exposure

It is in difficult market environments like this that low net equity long short hedge funds can be a successful source of diversification. It is, of course, untrue to say that hedge funds have outperformed traditional 60/40 portfolios in the past bull market; they have not. But the comparison needs to take account of risk-adjusted returns, capital preservation in periods of stress and minimal correlation.

Long short equity fund benchmarks are often based on cash rates as opposed to other risk asset benchmarks. This is especially the case for low net/market-neutral strategies which have limited beta, or market, exposure. The last bull market was also a period where interest rates consistently fell and liquidity was ample – distorting the risk-return of bonds and some parts of the equity market (such as high growth tech stocks).

The world and markets have dramatically changed since late 2021 when central banks, woefully behind the curve, begun to react on inflation. Looking ahead, investors like ourselves are struggling to find parallels to the current set-up (war, inflation, interest rate hikes, oil shock) in our living investing memories.

On the face of it, the early 1970s era of stagflation and Federal Reserve tightening throws up the closest comparison. Even in that period government bonds did well in nominal terms, with most of the pain in 60/40 taken by equities.

Equity long short strategies are fairly simple in many regards: they take long positions in things they like and shorts in things they don’t. The hedge fund world is a wide-ranging asset class encompassing various products and risk profiles. Low net long short equity hedge funds are typically lower risk than their long-only counterparts with a fraction of the volatility. This is because they can utilise derivatives to short both individual stocks and indices, with the latter either by index futures or options.

Many long short hedge funds, however, have taken quite a lot of market (beta) risk which is why some strategies don’t hold up in severe market drawdowns. This is why we favour a low net strategy, which limits the amount of market risk a manager can take and thus allows for both protection against market drawdowns and limited correlation.

Opportunities to minimise risk

Another less talked about benefit of long short equity strategies is that entire risk factors (sector, factor etc) can be minimised.

For example, predicting the oil price and the trajectory of commodity stocks is particularly difficult right now. It entails understanding the duration of the Russia/Ukraine war and/or the future state of the Chinese property market – and essentially predicting geopolitics. A long short hedge manager can minimise this risk from his or her portfolio by simply having no long or short exposure to commodity stocks.

Risks that are simply too hard to call - or are quite honestly beyond the expertise of a fund manager - can be avoided, with a focus on risks in areas of higher expertise.

We have entered a new regime in financial markets, one that does not resemble anything of the past 20 or even 30 years in financial markets. With inflation high, the unpredictability of war and pandemic disruptions, and in a world with high levels of absolute debt to GDP, we would expect continued volatility and periodic failures of some of the relied upon diversification tools of modern portfolio theory. Low net long short hedge managers can offer something different.

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