Equity long/short hedge funds battle to find alpha as correlation remains high

Is the long/short equity strategy too crowded?


David Shukis, Cambridge Associates
After a long record of producing some of the highest returns among hedge fund strategies, long/short managers as a group have lagged other strategies over the past three years. Some have attributed this disappointing performance to crowding in the long/short area, observing that a handful of names appear in a large number of long/short funds which limits the potential alpha of long/short ­managers.

It is true that there has been an increased concentration of assets in popular names like Apple, Microsoft, JP Morgan Chase and Google. These most widely held names appear in a higher percentage of long/short funds than they did three years ago. However, we think the lagging returns of long/short funds can be more accurately attributed to a cyclical market phenomenon, namely the reduced dispersion of returns among stocks. Typically, the internal correlation of the constituent stocks in the S&P 500 has been about 0.5.

Over the past three years, however, the correlation has risen to the 0.6 to 0.75 range. In this sort of market, where investors shift between ‘risk on’ and ‘risk off’ orientations, the opportunity for long/short managers to add value by differentiating between attractive and unattractive stocks is limited.

This market phenomenon appears to be typical of early recoveries, as a similar phenomenon can be observed following the 2000-02 bear market. We would expect dispersion to return to more normal levels over time which would improve the outlook for long/short managers. Before the recent correction there was evidence that this was occurring.

Nevertheless, finding alpha in long/short investing is always challenging. While talented managers can add value in the large-cap arena by insightful portfolio management, managers who look outside the largest, most popular names are likely to be rewarded. Smaller funds, which can hold mid and smaller-cap names, should be a source of added value as can funds focused in a region or sector. Incorporating these funds into a portfolio will add unique positions with superior return potential. We think carefully selected long/short funds will continue to add alpha to hedge fund portfolios over the long term.

Greg Dowling, Fund Evaluation Group
After the credit crisis there are fewer hedge funds and leverage in the system is low. The problem – and the reason the strategy feels crowded – is that correlation among hedged equity managers has remained stubbornly high post-crisis.

The market has been driven mostly by macro factors so intra-stock correlation has been elevated. This means most managers and most stocks have moved in lockstep. In macro markets fundamentals do not matter. Add in zero interest rates, lowering any possible short rebate, heavy government intervention in markets such as QE2 as well as higher fees (than traditional managers) and it equals disappointing results and calls of the space being crowded.

That, however, cannot last forever. At some point, fundamentals must matter. Hedge funds are merely unconstrained active management. If hedge funds cannot make money anymore, the implications to the asset management business are much broader.

The overall hedged equity space is not crowded. It is still as important to look for differentiated and unique managers. Great managers exist in a myriad of different places. Too many investors shop at the same store.

One of the most important things you can do is diversify family trees, even if it is a great family tree. Having too many managers from the same place of origin does not add much diversification. Even if they are investing in different stocks, they will approach putting on and taking off risk in a very similar way. Look for both small and large managers. Large managers may be able to afford best in class research and infrastructure, but size also limits the opportunity set. Finally, finding geographic or sector-focused managers can also greatly increase diversification and add unique sources of alpha.

Dorothy Weaver, Collins Capital
The equity long/short space is not crowded with truly differentiated managers that make money on shorts as well as longs. We are seeing ample opportunities for talented managers who can monetise market dislocations, pricing inefficiencies and idiosyncratic trade ideas.

During the 2003-07 bull market equity long/short strategies proliferated as many unproven and traditionally long-only managers crowded into the space in search of hedge fund fees. This led to the inevitable decline of opportunities. The 2008 financial crisis altered this dynamic as hedge fund assets were cut in half. Although painful, the cathartic consolidation of the industry ultimately benefited hedge fund investors by eliminating marginal funds and dramatically reducing competition. In equity long/short this has meant that managers that have survived are being rewarded with a more robust ­opportunity set.

We are focused on managers with differentiated approaches to idea generation and trade construction and who possess unique investment perspectives. We prefer managers who purposely fly under the radar as they are generally less correlated to their peers and the markets.

Managers cannot ignore macro considerations nor approach shorts as simply an inverse of a long. Trading as a source of alpha and low net exposures are also important characteristics in the current environment. Today, managers must demonstrate an ability to navigate choppy markets and protect capital in addition to finding differentiated investments.

Sean Molony, International Asset Management
We believe long/short equity exhibits some of the best fundamental hedge fund strategy attributes. Two of the attributes that we analyse are depth and liquidity. These are both positive for this strategy.

While there a large number of managers within this strategy, the world equity market capitalisation was over 75 times larger than industry estimates of the assets managed by long/short equity specialists at the end of Q2. Managers are predominantly invested in large capitalisation stocks that are liquid. The breadth of equity markets allows managers to diversify across multiple geographies, investment styles, sector and stock capitalisations. While we observe that individual stocks and themes can get crowded from time to time, we see no evidence that the strategy is overcrowded as a whole and nor do we hear such comments from managers.

Historically, stocks where there is a high concentration of ownership by long/short equity managers significantly outperform those with the lowest concentration. Over the last 18 months, however, while downside protection has been robust, the return capture has not kept up with the ­historic results.

We believe the risk on/risk off conditions that have characterised equity markets during this period have meant there have been sharp rotations in sector and stock movements in the underlying markets and that these factors have made it more challenging than normal for fundamental stock pickers to outperform. However, we would expect a resumption of outperformance once market conditions become more constructive.

Robert Marquardt, Signet
We must expect there to be less excess liquidity available to drive investment markets in a period of austerity and deleveraging. There is a secular phenomenon developing as private investors derisk, pay down debt, become disenchanted and become less active and interested in investment markets. Simultaneously, corporations in aggregate in the developed world are using cash to de-lever and compensate for rising input costs rather than investing excess liquidity in investment markets.

Banks and financial intermediaries and providers of credit are also finding themselves generally in a period of balance sheet repair and deleverage. Developed world governments are rapidly entering a prolonged period of austerity. So, the excess liquidity needed to drive markets ought to remain muted for the foreseeable future until debt loads are reduced.

There may be less free float around in the coming years to support or cause equity values to rise.

Equities typically rise in value when liquidity is expanding, profits can be expected to rise and interest rates fall on a forward-looking basis. This is not now.

While this should cap equity values, we might remain sanguine about underlying economics as hyper-supportive monetary policy across the developed world supports the economic environment during this continued unwind of excess.

There should be sufficient liquidity for economic repair to continue but limited excess liquidity to drive equity multiples and asset prices in bull markets.

Hedge fund managers depending on fundamental improvements (not events or special situations) in equities to cause price appreciation over time, with a hedge, can be expected to continue to disappoint. Even if companies grow and improve, it may not be reflected in markets for years.

Managers who invest relative value based on price relationships might also disappoint as the noise and nonsensical price nature of lower volume markets can cause mispricings to remain longer than an investor can remain invested.

Quantitative statistical arbitrage managers may be successful but there is too much money chasing the same anomalies so alpha is picked over and not likely to generate greater than Libor plus 2%-3% with tail risk.

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