Lonsec reviews the Long Short Global Equities sector.

Investment research house Lonsec Research Pty Ltd (Lonsec) recently completed its review of the Long Short Global Equities sector, reviewing 16 financial products.

This included two financial products new to Lonsec’s coverage: the Morphic Global Opportunities Fund (a recently launched strategy by Hunter Hall alumni) and the Platinum International Health Care Fund.

“Long/short investing is ostensibly based on the notion that, by unshackling fund managers from one of the most fundamental investment constraints (i.e. long-only investing), in theory; this should provide these active managers with greater chance of outperforming,” said Lonsec’s Senior Investment Analyst, Rui Fernandes.

“The reasoning being that in lifting the short constraint this would open up a whole new way for active managers to express their views on stocks. They can like a stock and own it; dislike it and avoid it; or hate it and short it.”

Regulatory change impacts sector

Regulatory change has firmly touched the sector, although the full impact remains unclear at this time.

ASIC released Regulatory Guide 240 in September 2012 dealing with enhanced disclosure requirements for hedge funds. The requirements of RG240 had been due to take effect from May 2013, however in response to additional industry feedback the start date has been postponed to 1 February 2014 to allow for further consultation between the regulator and industry players.

“The key issue for long/short funds is that they may be captured within the definition of a hedge fund, which has ripple effects,” said Fernandes.

“Firstly, there is the potential for platforms to revisit their own categorisation of products, which could have an impact on how products are used by financial advisers.”

“Notably, in Lonsec’s discussions with fund managers they mentioned that the general response from platform providers and key clients was that, provided the investment philosophy and process remained the same, it would be ‘business as usual’.”

“Secondly, this is likely to touch on the day-to-day relationship between financial advisers and their clients. The suitability of a product within a client’s portfolio could come into question where ASIC has now defined a product as a ‘hedge fund’ and a client’s risk parameters prohibit sophisticated ‘hedge fund’ or alternative investments.”

Lonsec also spoke to fund managers in terms of their prospective intentions to change financial products in order to avoid being captured by RG240. All fund managers which were queried maintained that they would not be revising their strategies (e.g. cancelling stock shorting) in order to avoid ‘hedge fund’ classification with this option typically ruled out early.

Unexpected competition

“Long short funds have typically been used by financial advisers as lower volatility or downside protection plays on, for instance, global or Asian equities,” said Fernandes.

“This is because of the flexibility that most strategies have in terms of not only varying their equity market exposure, but also ability to use a range of sophisticated techniques to dampen risks.”

Institutional investors have had access to another class of strategy which has sought to outperform the market through downside protection and with notably less volatility. Quantitative managed volatility equity strategies have been available institutionally for a number of years now; however access to these strategies in the wholesale/retail marketplace has only recently occurred.

“Those managed volatility products researched by Lonsec tend to be notably cheaper than these long short offerings—both in terms of ongoing annual fees and performance fees,” said Fernandes.

“Despite the computer-driven investment approach, they could be argued to be less complex. For instance, managed volatility strategies are long-only products which do not use any derivative overlays and are fully invested at all times.”

Investors likely have mixed emotions towards quantitative strategies given the significant difficulty, generally, this approach to investing experienced during the Global Financial Crisis. A bias against quantitative management could certainly rule out managed volatility strategies from consideration.

Further, the track record of these financial products in Australia is very short which may limit their appeal to some.

“For financial advisers who are using long short global strategies in client portfolios on the basis of downside protection and lower volatility, managed volatility strategies can offer a compelling after-fee case which may grow stronger in time as track records lengthen,” said Fernandes.

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