May 2017 Revisiting the role of long/short equity in a portfolio
Executive summary Omar Aguilar, Ph.D. Chief Investment Officer, Equities and Multi-Asset Strategies; Charles Schwab Investment Management, Inc. Long/short equity, the most common form of liquid alternative strategy, allows for flexibility as to how much market exposure or beta a manager chooses to take on in various market environments. Long/short equity has much to offer investor portfolios, including the potential for improving the overall risk-return profile while dampening portfolio volatility. But as the range of long/short equity offerings expands, advisors and other investment solution providers may find that they need a clearer process for evaluating wide-ranging options. Here, we offer a review of the potential benefits of long/short equity in the context of a portfolio, and include a checklist for assessing and comparing different strategies. Jonas Svallin, CFA Vice President, Head of Active Equity Products; Charles Schwab Investment Management, Inc. 1 2 3 Read on to learn How long/short equity can buffer downside exposure while expanding the efficient frontier in portfolios Why a risk-adjusted return measure is the most appropriate metric How to evaluate apples-to-oranges options within the long/short strategies Why long/short equity could be particularly attractive today 2 Revisiting the role of long/short equity in a portfolio For Institutional Investor Use Only
Introduction While many advisors and investors are familiar with the broad strokes of long/short equity strategies, they may have misconceptions or outdated assumptions about how such strategies actually work. After all, the early iterations by hedge funds often looked quite different than the regulated versions now available in mutual funds and other vehicles. Thanks to its lower correlation to the broader equity market and ability to short stocks, long/ short equity is designed to perform most favorably during periods of rising volatility or in declining markets both backdrops that could emerge as policymakers reduce the extreme liquidity of the post-financial crisis environment. Therefore we encourage advisors and other investment solution providers to use this primer as a review of long/short hedged equity strategies, and as a guide for how to evaluate the ever-longer list of strategies competing for market share. How long/short equity can serve investor goals In the context of overall portfolio construction, long/short equity strategies offer a number of attributes that can help investors reach portfolio goals. Attractive risk-adjusted returns One of the most important metrics of historical performance for any strategy is a measure of risk-adjusted returns. Though long/short equity approaches and characteristics can vary widely across competing products, return-per-unit-of-risk offers a uniform way to compare historical performance, and is often evaluated using something known as Sharpe ratio. Whatever the approach to long/short equity, the investor should establish that any long-term returns are commensurate with the level of risk introduced by the strategy. What is long/short equity Long/short equity is an investing strategy of taking long positions in stocks that are expected to appreciate and short positions in stocks that are expected to decline, minimizing market exposure. Although this may not always be the case, the strategy would be profitable on a net basis as long as the long positions generate more profit than the short positions, or the other way around. The long/short equity strategy is popular with hedge funds, many of which employ a market-neutral strategy where the dollar amounts of the long and short positions are equal. For Institutional Investor Use Only Revisiting the role of long/short equity in a portfolio 3
Expanding the efficient frontier The short equity exposure in long/short equity can actually expand the efficient frontier, the proverbial set of optimal portfolios that offers the highest expected return for a defined level of risk. This broadening of possible returns for a given level of risk, can be achieved by reducing overall market exposure (beta) and adding a new source of stockspecific returns (alpha) through the short sale of stocks. Thus, the traditional efficient asset frontier can shift up, offering the prospect of greater returns for the same level of risk (see Figure 1). Reducing overall portfolio volatility Long/short equity strategies typically have a lower correlation to equity benchmarks than traditional long-only strategies, thanks to the flexible combination of beta and alpha on both the long and short positions. Essentially, a portion of holdings are correlated with benchmarks, while the rest are not. The holistic effect is that long/short strategies can dampen overall portfolio volatility compared to traditional long-only equity. Compared to a traditional 60/40 equity/cash portfolio, allocating a portion of equity exposure to a long/short equity benchmark would have increased risk-adjusted returns, or sharpe ratio, and lowered overall portfolio volatility over the 10-year period ended December 31, 2016 (see Figure 2). Figure 1: Expanding the efficient frontier Long/short equity strategies can expand an investor s opportunity for higher risk-adjusted portfolio returns. Figure 2: 10-year track record Allocating to long/short equity would have boosted riskadjusted returns, while lowering overall volatility. For illustrative purposes only Source (both charts): Charles Schwab Investment Management. Data for the 10-year period ended 12/31/2016. Equity allocation represents the S&P 500 Index. Cash allocation represents the Citibank 3-month T-bill. Long/short equity allocation represents the BarclayHedge Equity Long/Short Index. 4 Revisiting the role of long/short equity in a portfolio For Institutional Investor Use Only
Downside protection in falling markets The hedging function in long/short strategies can dampen portfolio drawdown in falling markets, one of the most compelling reasons to move a portion of equity allocations to such strategies. While a below-market beta drives much of that benefit, alpha from shorts and longs can potentially add returns in any investment environment. Combined, these features often protect drawdown risk in falling markets. Not all strategies are created equal in this respect, but the fundamental structure of long/short equity typically creates a lower downside capture than traditional equity thus increasing investor return over time (see Figure 3). When volatility is rising Most long/short equity strategies rely, to some extent, on stock picking. As such, they stand to perform well in environments where correlations among stocks are falling, offering more differentiation and alpha for stock-pickers. The unprecedented liquidity sparked by the persistently low interest rate environment in the post-financial crisis era has contributed to rising stock correlations around the globe. As policymakers in the U.S. appear poised to continue on the path of raising interest rates, and incrementally withdrawing liquidity from the financial system, we anticipate a step down in stock-to-stock correlations. Market environments where long/short equity can excel Long/short equity strategies can potentially perform well in just about any environment. In rising markets, they usually do not keep pace with traditional stock benchmarks, thanks to belowmarket beta but still, they tend to participate in market upside along with the benchmark. In falling markets, the hedging function kicks in, potentially buffering downside capture. Figure 3: Reducing maximum drawdown Allocating to long/short equity can partially shield a portfolio from unexpected market-moving events by reducing maximum drawdown. Sources: Charles Schwab Investment Management; Zephyr. Data for the 10-year period ended 12/31/2016. Maximum drawdown represents the maximum loss from a peak to a trough of a portfolio, before a new peak is attained. Maximum Drawdown is an indicator of downside risk over a specified time period. Past performance is no guarantee of future results. Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly. For Institutional Investor Use Only Revisiting the role of long/short equity in a portfolio 5
Practical steps for comparing long/short equity options Long/short equity strategies can take on a wide range of profiles. Some are directional, retaining market beta exposure so that they rise and fall in tandem with the broad market, while others hedge market beta almost entirely and rely only on long and short stock-picking alpha for returns. Some strategies never use leverage, while other strategies use short positions to leverage their long positions (such as 130/30 portfolios). Because strategies can vary widely, comparing different strategies is inevitably a case of apples to oranges. Here are some of the questions to ask when evaluating options, along with the best metrics to consult in your research. Checklist for evaluating long/short equity strategies Has it delivered sufficient return for the level of risk? A keen focus on return-per-unit-of-risk provides a consistent way to compare historical performance across long/short equity competitors. Whatever the approach to long/short equity, long-term returns should be commensurate with the level of risk introduced by the strategy. Evaluate the strategy s Sharpe ratio, and compare to peer strategies and to traditional equity. What flavor of hedged equity is it? Look to the strategy s standard deviation of returns for some clues on where it falls on the risk spectrum. Market-neutral strategies could have bond-like volatility, while most unleveraged long/short strategies will typically have volatility between stocks and bonds. Those that use leverage or have high net positions could be considerably higher on the risk spectrum. Evaluate the strategy s standard deviation of returns to get a sense of the risk and volatility level. What is the investment team s process and short-selling experience? Shorting stocks has some specific nuances compared to long-only investing, so investigate the investment team s experience and process for short selling. For instance, an investment team may hold on to a long position until the market realizes its valuation potential, but on the short side, they may require more clearly defined catalysts that support the likelihood that a company will disappoint on financial performance. Look at the investment team s experience, and look for systematic and repeatable processes for determining short sales and long positions. What are gross and net exposures in a long/short strategy? Not all long/short strategies are constructed the same, so both the gross and net exposures should be part of evaluating a fund. Gross exposure is the sum of the long and short percentages of the fund. While net exposure is the difference between the fund s long positions and its short positions. Looking at one without the other can give an incomplete picture of the strategy. The gross and net exposures can offer a quick sense of the risk level for a long/short strategy, including if it deploys leverage. For instance, a 130/30 strategy uses funding from 30% short positions to purchase another 30% on the long side, indicating leverage. How would it affect a portfolio? Standalone measures are important, but it s also crucial to understand how a strategy would pair with existing portfolio holdings. This allows you to evaluate the incremental benefits of adding it to an overall allocation. Look at the beta and correlation of returns of the strategy to traditional asset classes. Lower beta and correlation measures suggest a higher diversification benefit when adding a strategy to an allocation. Has it performed as expected in various market environments? You ll want to evaluate historical performance, but not just to see if the strategy has performed well. Look specifically for whether a strategy performed as it should have in specific market environments. How was performance in the last one or two pullbacks, or in sideways markets? What are the upside/downside capture levels? Evaluate the strategy s upside and downside capture metrics, and look at absolute performance in periods where markets were rising, falling, or flat. 6 Revisiting the role of long/short equity in a portfolio For Institutional Investor Use Only
Falling markets Downside preservation is the other marker of long/short equity strategies. In extreme pullbacks, long/short strategies tend to fall less than the overall market given their lower correlation to the market, preserving wealth. Market-timing is never the goal of portfolio construction, but an allocation to a long/short strategy can position a portfolio for more favorable relative performance whenever the next bear market arrives, a point that may be particularly important to investors after an extended period of market appreciation. Positioning investor portfolios for the long term Selection among long/short equity peers matters, but the asset class is compelling. Adding a long/short equity strategy to traditional portfolios can buffer downside risk in difficult environments and add alpha in rising markets, especially during periods of higher volatility. When added to traditional portfolios, it can offer both incremental risk-control and return potential, expanding the efficient frontier while reducing overall downside capture. But it s critical to understand the differences among competing strategies as you evaluate options for clients. The normal standards of evaluation, like continuity of fund management and consistency of process, are as important in this category as they are for any active strategy. But you have to look under the hood at each product, evaluating a strategy at the holdings level as well as by measures of historical risk and return. For Institutional Investor Use Only Revisiting the role of long/short equity in a portfolio 7
Charles Schwab Investment Management As one of the nation s largest asset managers, our goal is to provide investors with a diverse selection of foundational products that aim to deliver consistent performance at a competitive cost. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. The information here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities and investment strategies mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. Charles Schwab Investment Management, Inc. (CSIM) is an affiliate of Charles Schwab & Co., Inc. and a subsidiary of The Charles Schwab Corporation. 2017 Charles Schwab Investment Management, Inc. All rights reserved. REF (0517-VK9X) MKT96994-00 (05/17) 00193747 For more insights, visit us at csimfunds.com