Welcome to 2016, where headlines scream about the prospect of bear markets, accompanied by images of screens showing an endless sea of red. Global markets are concerned about a trifecta of higher rate expectations from the end of US quantitative easing (QE), a China meltdown causing risk-off contagion, and the possibility of a commodity crash causing broad issues in credit markets.
The Australian market has experienced significant volatility so far this year and this seems set to continue. In a ‘risk-off’ environment, the companies that suffer most tend to be resources and financials, which, in combination, comprise more than 60% of the S&P/ASX200 Index (ASX200).
The eight year bull-run will turn into a bear market at some stage, whether that’s happening now or in months or years to come; regardless, investors need to consider strategies to preserve their capital.
One strategy to consider is investment in a long/short fund. Long/short equity strategies aim to provide investors with positive returns, whatever the market conditions.
Long only strategies, such as traditional equity funds and equity ETFs, will follow the equity markets; this may result in investors potentially losing a considerable amount of their capital in a significant bear market. Once capital is lost, it takes a substantial gain – and time – to recoup those losses. As illustrated in Figure one, a loss of 50% (remember the GFC?) requires a 100% gain to get back to square one.
Well run long/short strategies use short positions to protect on the downside. The best ones may appreciate in value when equities are going down.
Australia – a concentrated market
Given the prevailing conditions in global markets, it is particularly hard to avoid that volatility in Australia when you have such a high concentration of companies within our market. In fact, Australia has one of the most highly concentrated equity benchmarks in the world (surpassed only by New Zealand and Finland).
The Australian sharemarket is small by global standards and is dominated by a small number of large companies – the top 20 stocks comprise approximately 60% of its market capitalisation. When using a benchmark for constructing an equity portfolio – such as the ASX200 – the performance of a traditional fund that takes long only positions will be determined by the size of that fund’s holding of those very large companies relative to that company’s weighting in the benchmark. ETFs that mirror the index face the same issue.
It is very difficult for a traditional long only equity manager to deliver positive returns in a volatile market while managing a fund to an equity benchmark such as the ASX200. Trying to beat that benchmark means that portfolios can become concentrated, or take on style bias with managers leveraging themselves to macroeconomic shocks if there are big style shifts. This can be especially risky during periods of volatility.
In contrast, a long/short fund can also take short positions by borrowing shares from other holders and selling on market, then reinvesting the proceeds in other long positions. This provides a long/short strategy with a larger set of investment opportunities and puts it in a better position to generate returns above the benchmark.
Long/short funds may deliver positive returns in a volatile environment
As the name suggests, a long/short equity strategy holds both long and short equity positions – in other words, it is a strategy that allows an investment manager to act with true conviction.
If the manager believes a company’s share price will appreciate, it can go long and buy shares in that company. Conversely, if the manager believes a company is overpriced or unlikely to prosper due to structural, economic or company-specific factors, they can go short and sell its shares.
Managers of long/short funds doesn’t just look for the good news stories like the majority of Australian equity managers – they can take advantage of negative views of stocks and sectors, as well as weaker fundamentals.
A long short equity strategy seeks to profit from share prices appreciation above the index in its long positions and price declines below the index in its short positions.
There are two primary benefits from employing a long/short strategy:
- The investment manager can tap into underperformance of the market by identifying losers as well as winners. Traditional managers leave that information on the table as they can’t do anything with it. A long/short fund unlocks that potential and gets extra returns out of the ‘losers’.
- Increased diversification – because of the concentrated nature of the Australian equity benchmark, traditional managers are often forced to take concentrated positions. Rather, the combination of long and short positions potentially enables greater diversification which may help to mitigate risk, particularly in a volatile market.
The opportunity to take both long and short positions allows for more active decision making. This flexibility allows the portfolio to more accurately reflect the outcomes of the underlying investment process where the manager is really adding value.
There is the potential to achieve higher levels of return relative to the benchmark than can be achieved for funds which only take long positions. However, this is partly achieved by taking additional risk. The incremental risk reward trade-off may be more attractive than that offered by long only funds.
Over time, markets will go through large swings, both up and down. Investors need something genuinely different from long only equities to help protect them; well-run long/short strategies offer a genuine alternative to preserve capital in a bear market.
Click here to read CPD: Strategies to survive a bear market – Part II
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