Advisers need to recognise the benefits and risks associated with a long/short investment approach.
Investors and advisers alike are most familiar with ‘long-only’ investing. Short selling is often perceived negatively and attributed to day traders. However, as outlined in this article from GSFM, a long/short strategy might result in better returns and lower volatility for investors.
What is a long/short equity strategy?
Long/short equity strategies are designed to achieve equity like returns with less volatility than the equity market. At its most basic, a long/short strategy seeks to profit from share price appreciation in its long positions and price declines in its short positions. Such strategies aim to provide investors with returns that beat their respective benchmark, whatever the prevailing market conditions.
In managing a long/short strategy, the investment manager can benefit from rising share prices by taking a long investment position in selected companies they believe will rise in price. They can also profit from falling share prices by taking a short position in companies they expect will fall in value.
Most investors tackle share market investing by taking a long position in a portfolio of shares. However, by adopting an approach that shorts stocks in tandem with a buy and hold approach – a long/short strategy – investors have access to a larger universe through exposure to a portfolio that profits from both positive and negative share price movements. Such a portfolio can be better positioned to ride out market volatility.
How does this strategy work?
Freed from the constraint of long only investing, a long/short equity manager can look beyond the good news stories and take advantage of negative views of companies and sectors, as well as weaker market and stock specific fundamentals.
The long/short equity manager aims to exploit the upside of companies with a positive outlook and sound growth prospects by taking a long position. The goal is to capture an increase in value through this position. In a long/short equity fund, managers buy the stock outright, just as in a traditional long-only equity fund.
When a manager believes a company will experience a fall in its share price, they may establish a short position. In simplest terms, they borrow the stock – typically from a broker – sell the borrowed shares to another buyer and collect the proceeds. If the price of the stock has declined, the manager will be able to purchase the shares in the open market at a lower price than those they sold. Shorting a stock is profitable if the stock price falls between the time it is borrowed and the time it is returned. It’s important to note that naked short selling is illegal in Australia, so all short positions taken are ‘covered shorts’.
This combination of long and short positions provides the manager with a large degree of flexibility and enables more active decision making.
Short selling has been a controversial topic in Australia and has often been unfairly blamed for creating excessive volatility in markets. However, short selling doesn’t change the underlying fundamentals of a business; in fact, it creates opportunities for investors with differing views, aids in price discovery and provides greater market depth.
What is an active extension strategy?
Some long/short equity strategies are also known as ‘active extension strategies’. In an active extension strategy, the investment 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 and reinvest the proceeds; this provides the strategy a greater exposure to the market than a long only strategy. Other active extension strategies such as 130/30 and 120/20 are also common.
Active extension strategies allow stock pickers to better express their highest conviction stock ideas by increasing underweight and overweight positions relative to the index. They can ‘short’ poor companies with weak financial fundamentals and use those proceeds to increase their ‘long’ positions in the highest quality companies.
Why invest in a long/short equity strategy?
There are several reasons to include a long/short equity strategy in your clients’ portfolios.
Enhanced return potential
Long/short equity managers have the potential to exploit two sources of investment return and act on research and analysis irrespective of it indicating 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.
Long/short equity 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.
Mitigate volatile markets
Long/short equity strategies aim to provide investors with positive returns, irrespective of market conditions. During periods of market volatility, such as those experienced to date in 2022, long only strategies will typically follow the respective equity market. This may result in investors losing capital, particularly in the event 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. A strategy that minimises losses can better position investors to weather market drawdowns.
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.
A diversified approach
Diversification is the cornerstone of every investment portfolio; however the Australian market tends to be skewed, creating a challenging environment for managers due to concentration and crowded trades.
The Australian share market is small by global standards, representing approximately two percent of world markets. Our market is also concentrated. Unlike other developed markets, Australia is dominated by a small number of large companies – in fact, the top 20 stocks comprise approximately 58%[1] of the market capitalisation of the S&P/ASX200 Index. In turn, this top 20 is dominated by financial and mining stocks.
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 can provide a more diversified portfolio.
By investing in stocks that are expected to rise in value, as well as making money from stocks that are expected to fall in value, an investor is effectively doubling the investment universe available, as well as smoothing out returns and mitigating a traditional long only equity portfolio risk. Shorting creates opportunities for diversification without high concentration risk.
Risk and return
All investments carry some degree of risk; long/short equity funds are generally considered to be a higher risk option because they carry a greater number of active stock positions. However, the ability to short and hedge can allow for better risk control.
Long/short equity strategies are generally style-neutral – unlike many long-only funds – and therefore not reliant on market timing. As such, a long/short equity strategy should deliver positive performance in any market cycle or through any style shift.
The main risk associated with long/short investing is that it amplifies the investor’s exposure to the manager’s investment skill. If the stock selection is poor, then the outcome will generally be worse than it would be for a more conservative long only fund.
There is also some additional risk in short selling, and this occurs if the borrowed stock is recalled. In this case, it can also force a repurchase of the share at the same time as the recall. Although this is not a common occurrence, it can happen, and it may mean the share has to be repurchased at a less than favourable price.
This risk can be managed by ensuring that the short positions held are mainly in liquid shares rather than in the smaller, lower liquidity assets whose price moves further in the event of a short squeeze.
Long/short equity strategies and the current market environment
As previously noted, Australia’s sharemarket is small vis-a-vie global markets, so it’s subject to the vagaries impacting those markets, particularly the developed markets.
The stimulus packages introduced by central banks to steer developed market economies through the Covid-19 pandemic are now coming to a halt, but not before accelerating inflation. The stimulus encouraged consumers – notably US consumers – who went and spent, creating supply chain issues and bottlenecks, which caused inflation to spiral.
Central banks have to slow their respective economies to prevent inflation spiralling out of control and they have done this using interest rates. High inflation will ultimately result in reduced demand, which stops the economy. So, it’s a balancing act for central banks to slow but not stop the economy moving and case recession.
A small amount of inflation can be good for the equity market because companies are good at putting up their prices and expanding margins; however, too much inflation and people stop spending. An environment where some companies can prosper, and others may see their earnings capacity shrink, can be one where a long/short equity strategy can benefit investors.
While a long/short equity fund is often considered to be a more appropriate strategy for those who are younger and in the accumulation phase of their investment life, there’s an opportunity to broaden the investor audience. Older investors, even those moving to the retirement phase, could consider a long/short strategy for some of their retirement savings. Longevity risk is a real concern for these investors and one of the greatest risks is that retirees will run out of money before they run out of life.
Increasingly, investors are realising that opting for a completely conservative investment allocation is not a viable solution. They recognise that there should be some allocation towards growth assets, and a long-short Australian equity fund may meet that criteria.
The equity market rarely prices a stock accurately and long/short equity strategies offer an investment approach that takes advantage of this…and in today’s market environment, the mispricing opportunities are many and varied on both the long and short side of the equation.
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GLOSSARY
Long – a long position arises from 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.
Covered short – the investor borrows the shares from a broker before entering the short position; in return, the investor pays a borrow-rate during the time the short position is in place.
Naked short – when an investor sells a security without having possession of it.
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.
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