By Donald A. Steinbrugge, founder and CEO, Agecroft Partners, LLC. There has recently been increased interest in long/short equity strategies after a strong relative performance in the 1st quarter of 2020 relative to equity indices and the perception that the recent sell-off and rebound in the marketplace have created an environment for long/short equity managers to excel. This is great news for approximately 25% of the hedge fund industry that focuses on the strategy after a decade-long decline in the percentage of total hedge fund industry assets. For investors looking to hire a long/short equity manager, it can be a daunting task narrowing down the thousands of funds focused on the strategy. Initially, investors focus on the typical evaluation factors for a hedge fund which include the quality of the organization, investment team, portfolio construction, and risk controls such as management of net exposures and position sizes of longs and shorts, and quality of service providers. In order to increase the odds of identifying a manager who will outperform, investors should also focus on three high-level areas:
• The relative valuation of the segment of the equity market in which the manager specializes
Relative valuation of markets Most managers run a long-biased portfolio with an average net exposure around 50% long. This results in a high correlation in performance to the area of stocks in which they specialize, and a meaningful portion of their performance driven by the beta to those stocks. Therefore, comparing performance across long/short equity managers is not a good indication of their relative quality. Instead, it is beneficial to consider the following: • Create a custom benchmark for each manager. Various components of the global equity markets perform differently year to year. In order to determine if a long/short equity manager is adding value, their exposure-adjusted performance should be compared to a custom benchmark based on the part of the equity market in which they specialize. For example, a long/short equity manager focusing on small-cap U.S. growth companies with an average net exposure of +60% should be compared to 60% of the Russell 2000 growth index. This is something that long-only investors have done for years but has been used much less frequently in the hedge fund industry. • Determine whether managers are biased to outperform. Investors should focus on long/short managers that are concentrated in the most undervalued areas of the global equity markets. This process begins with reviewing historical relative price-to-earnings ratios for different parts of the market such as small-cap versus large-cap, growth versus value, developed markets versus emerging markets, and the U.S. versus China. These ratios are then compared to their current levels to determine which part of the equity market seems to be relatively undervalued from a historical perspective. The next step is to try to identify if there are any changes in relative expected earnings growth rates across each of the areas evaluated that would have caused changes to relative valuations. Over long periods of time, temporary pricing distortions develop among different areas of the market which eventually reverse. This causes a rotation of outperformance for these various areas. Over the past century, the market has consistently overpaid for earnings growth and large-cap stocks, which has resulted in long-term outperformance of value and small-cap stocks. This performance trend has reversed itself over the past decade. This reversal has created an environment where value and small-cap stocks are trading at valuations levels near their all-time lows relative to growth and large-cap stocks. The question is, has the world changed or will we see a huge snap back in the performance of small-cap and value stocks?
Level of inefficiencies
Information advantage
1. Food chain analysis It is also important to understand what a manager is doing differently on the short side of their portfolio. Investors find managers with demonstrated skill in security selection and execution on the short side of the portfolio to be adding substantial value. Some managers do not actively short individual stocks and may use cash or equity market indices to broadly hedge their portfolios. Other managers who are actively shorting individual equities may do so in a couple of ways: pair trades that directly hedge a portion of the portfolio or alpha shorts where their main objective is to generate profits. Most managers tend to use a shorter time horizon for shorts, given the expense of shorting due to the high cost of borrowing some of the more crowded stocks. They also tend to have smaller positions, due to the inherent unlimited downside of short positions. Summary The long/short equity manager universe is highly fragmented. Investors can increase the probability of achieving higher returns if they focus on managers concentrated in the relatively undervalued segments of the equity markets, along with areas of the market with greater inefficiencies. Managers should be selected that can clearly articulate their ability to gain an information advantage and capture market inefficiencies and whose skill can be quantified by the outperformance of a customized benchmark. For those interested in learning more, please register for our complimentary webinar on June 3rd at 11:30 ET (also available later on demand), "Long Short Equity, Where are the Opportunities and What Makes a Good Manager?" which will feature prominent institutional investors, and be co-hosted by Don Steinbrugge, CFA, Founder and CEO and Doug Rothschild, President of Agecroft Partners. Please click here to register: Article source - Opalesque is not responsible for the content of external internet sites |
Industry Updates
How do you select a long/short equity hedge fund manager?
Tuesday, May 26, 2020
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