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The Long And The Short Of It

Date: Wednesday, August 8, 2012
Author: Gilles Sitbon, on Brian Bollen's Blog

by Gilles Sitbon, fund Manager of Sycomore L/S Opportunities, and Olivier Mollé,fund manager of Sycomore L/S Market Neutral

What place do equity long/short strategies have in an investment portfolio? The current market environment has led some investors to completely avoid equity markets. But it is those kinds of uncertain and volatile conditions that make long/short strategies highly relevant today as they offer uncorrelated returns and reduced volatility.

Market conditions have proven difficult for equity managers for several years in a row now. A historically high degree of risk aversion and tighter regulations (Basel III and Solvency II…) have kept institutional investors away from the equity asset class.

In addition, most of today’s investment flows are controlled by opaque High Frequency Trading (HFT) platforms, while many of the markets’ movements have become driven by unpredictable political news flow which is structurally hard to model. These elements have led to an acute reduced visibility and a higher correlation between all asset classes, except maybe for some of the few perceived safe havens (Bunds, T-notes…) which are now trading at historically high valuations.

While the environment is hard to navigate for traditional long-only managers, it does however play to the strengths of a long/short approach. Conventionally, a long/short manager invests in a basket of securities. But, unlike her/his long-only counterparts, the manager can “short” stocks (where the equity is borrowed and sold to be bought back at a lower price, which allows to generate a positive investment returns when the price of the security declines).

There are two types of long / short strategies, each aimed at filling different investment needs.

“Market Neutral” long/short funds use a relative value approach, i.e. pair trades of securities belonging to the same sector, with little to no market exposure (absence of “beta”). As an example, the manager would buy Peugeot long and sells Renault short in exactly the same monetary amount, in the belief that the Peugeot/Renault valuation gap is going to be reduced over time.

The net exposure is continuously rebalanced to neutralise market exposure, meaning that the performance return of the pair is derived solely from the relative evolution of the price of the two stocks against each other. This strategy aims to take advantage of valuation anomalies that should mean-revert and diminish over time.

The result is an almost total disassociation from wider market gyrations and a performance that is driven only by the relative movement of prices for securities that trade in the same sector. This kind of strategy has an absolute return objective with a strong focus on capital preservation.

“Directional” long/short funds do take market exposure (use of “beta”) and adjust dynamically this net exposure at the discretion of the manager. Unlike “Market Neutral” funds with their relative value approach, there are two discrete performance clusters for Directional funds: the long and the short book. The long side of the portfolio uses a traditional stock picking approach, similar to what one might see in a long-only fund. The short side of the portfolio complements the long side of the portfolio. There are all kinds of shorts: structural or terminal shorts (equity expected to become worthless), accounting shorts (misrepresentation of economic reality by use of questionable accounting), fraud shorts, competition shorts, cyclical shorts (where consensus has not adjusted up or down to modified expectations in the manager’s opinion). For both the longs and the shorts, the objective is to take advantage of asymmetrical investment scenarii with the aim to generate long-term returns, with a reduced volatility.

The principal interest of long / short strategies is to offer uncorrelated performance and reduced volatility, which makes them highly relevant in today’s environment for at least two reasons. First, market dismal returns over the past five years, and the historically low interest rates environment on safe investments (both the interbank lending rates and the low risk sovereign notes in particular) have pushed investors to seek investment solutions able to offer higher returns without compromise on their risk constraints. Long / short funds can help address that goal. Secondly, recently the “risk-on / risk-off” behavior and the undiscriminated unwinding of positions in times of market dislocations have created wide valuation discrepancies between sectors, asset classes and investment styles, which in itself creates a vast pool of very attractive investment opportunities. .

How should investors position themselves in this environment? That really depends on their investment objectives. A risk-averse investor, who wishes to generate returns with the principal aim to preserve capital might look to a long/short Market Neutral fund. Separately, an investor who wishes to get equity market exposure with a reduced volatility and that might be targeting equity-type returns over the investment horizon could opt for more for a Directional long/short approach.