Long/short investing – a true conviction strategy

A long/short equity strategy, as the name suggests, holds both long and short equity positions in its portfolio. In recent months there’s been a surge of flows into these strategies – in this article, Grant Samuel Funds Management explores the rationale for investing in a long/short equity strategy and why that might explain the uptick in inflows.

What is a long/short strategy?

A long/short equity strategy combines both long and short investing. It seeks to profit from share price appreciation in its long positions and price declines in its short positions.

If an investment manager’s research indicates 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. In other words, it’s a strategy that allows an investment manager to act with true conviction.

Long/short equity strategies provide investors with two sources of potential return, from both long and short positions, rather than the sole source of return that comes from long only investing.

How does a long/short strategy work?

The manager of a long/short equity strategy aims to exploit the upside of companies with a positive outlook and sound growth prospects, and the downside of those with a negative outlook and poor prospects.

A long/short strategy combines long investing or buying shares in companies that are expected to increase in value, as well as short selling shares in those companies that are not.

Freed from the constraint of long only investing, a long/short manager doesn’t just look for the good news stories like traditional equity managers – it can take advantage of negative views of companies and sectors, as well as weaker fundamentals.

Short selling is a way to profit when a company declines in value. The mechanics of short selling involves borrowing stock from a lender (a broker or a passive index fund) with an agreement to return the stock in the future. The stock is then sold in the market, raising cash which can then be invested in a long position in another stock.

When the short trade is closed, a long stock is sold, and the cash is used to repurchase that short stock and return it to the lender. As long as the shorted stock has delivered a worse return than the long stock (fallen more or risen less), then the trade will be profitable. This process may be conducted many times across a long/short portfolio to generate higher investment returns.

Short selling example:

A long/short equity manager sells shares in ABD Limited at $20.00; these are shares they have borrowed but don’t own. The manager buys the shares back when the share price has fallen to $15.00 per share, booking a profit of $5.00 per share, less fees and costs.

Some long/short equity strategies are also known as an ‘active extension strategies’ in which   the manager shorts some stocks and then reinvests the proceeds in additional long positions to achieve a net stock exposure of 100%.

Figure one illustrates the workings of a 150/50 long/short equity strategy; in this scenario, the manager can short up to 50% of its market value, although the proceeds need to be reinvested so that the Fund maintains full exposure to the market. Other active extension strategies such as 130/30 and 120/20 are also common.

 

 

Why invest in a long/short strategy?

There are several reasons to include a long/short strategy in your clients’ portfolios.

Additional source of return

Long/short equity managers have the potential to exploit two sources of investment return and act on research and analysis that shows a positive or negative outlook. The manager can add value by short selling a range of stocks with weak investment characteristics and reinvesting the proceeds in long positions in preferred stocks. This combination of long and short positions provides the manager with greater flexibility and enables more active decision making.

Full spectrum of investment insights

Long/short managers can benefit from all of their research and analysis – rather than just avoiding a company because of weak fundamentals, short selling a company’s shares is a way to potentially enhance returns. It can be better to exploit a weakness in a company or sector through an explicit short sold position than simply holding an underweight or zero position.

Attractive risk-return trade off

Long/short strategies aim to provide investors with positive returns, whatever the market conditions. During periods of market volatility, long only strategies such as traditional equity funds and equity ETFs will follow the respective equity markets; this may result in investors losing capital, particularly in the case of a significant market correction or sustained bear market. As illustrated in figure two, once capital is lost, it takes a substantial gain – and time – to recoup those losses.

 

 

 

The opportunity to take both long and short positions provides an investment manager with a greater degree of diversification and 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 can be more attractive than that offered by long only funds.

Australia’s concentrated market

The Australian share market is small by global standards and is dominated by a small number of large companies. In fact, the top 20 stocks comprise approximately 55%[1] of the market capitalisation of the S&P/ASX200 Index.

When using a benchmark for constructing an equity portfolio – such as the S&P/ASX200 Accumulation Index – 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 index.

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 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 index. In short, a long/short Australian equity strategy addresses the great limitations for long only active investors in the Australian equity market; the constraint that comes from a very concentrated benchmark.

What are the risks?

All investments carry some degree of risk; long/short funds are generally considered a higher risk as they carry a greater number of active stock positions.

The main risk associated with long/short investing is that it amplifies the investor’s exposure to the manager’s investment skill. If the manager selects stocks poorly, then the outcome will be worse than it would be for a more conservative long only fund.

There is some additional risk in short selling. If the borrowed stock is recalled it may force a repurchase of the stock at the same time; while it’s quite a rare occurrence, it can happen.

Surging interest

A recent sector report released by Zenith Investment Partners found that the amount invested in Zenith-rated long/short Australian equity strategies surged 43% in the 12 months to March – and 78% over four years – growing from approximately $6.1 billion to $8.7 billion.[2] According to Zenith’s report, the extended equities markets bull run is largely responsible for driving this demand.

Because short selling allows investors to profit when shares or markets decline, the appeal of long/short equity strategies has been gathering momentum as predictions about the end of the current bull market also gather impetus.

If your clients are concerned about the potential for a market correction and the impact on their portfolio, rather than selling out of equities, encourage them to rethink their investment approach. Whether they hold direct equities or long-only equity funds, whether exchange traded funds, listed investment trusts or companies, or managed funds, it’s worth taking a closer look at long/short equity strategies as a way to maintain exposure to equities in all market conditions. As with all investments, each strategy has its differences, so be sure to examine it to ensure its risk return profile suits your client.

Glossary

Long – a long position comprises the purchase of a security with the expectation that the asset will rise in value.

Short – a short position results from the sale of a borrowed security with the expectation that the asset will fall in value.

Short squeeze – occurs when an event changes the prospects of shorted stock for the better; this tends to result in a sharp rise in the stock price, amplified by short sellers covering, or buying back, the stock to close out their position.

Market drawdown – the potential loss or decline of an investment

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[1] Source: ASX200 List as at 1 July 2018
[2] https://adviservoice.com.au/2018/07/investor-demand-for-downside-protection-drives-surge-in-australian-shares-long-short-strategies/

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The information included in this article is provided for informational purposes only. The information contained in this article reflects, as of the date of publication, the current opinion of Grant Samuel Funds Management and is subject to change without notice. Sources for the material contained in this article are deemed reliable but cannot be guaranteed. We do not represent that this information is accurate and complete, and it should not be relied upon as such. Any opinions expressed in this material reflect our judgment at this date, are subject to change and should not be relied upon as the basis of your investment decisions. All reasonable care has been taken in producing the information set out in this article however subsequent changes in circumstances may occur at any time and may impact on the accuracy of the information. Grant Samuel Funds Management, its related bodies and associates do not give any warranty nor make any representation nor accepts responsibility for the accuracy or completeness of the information contained in this article. © 2018 Grant Samuel Funds Management.