If long-short equity managers can’t beat the market, what purpose do they serve? That’s a question investors are rightfully asking after 2008, when so many such managers were buried. Even the Tiger cubs, offspring of Julian Robertson Jr.’s famed Tiger Management Corp. and purported masters of the art, had a rough time of it — although most did better than cub Stephen Mandel Jr., whose Lone Cypress fund was down 32.56 percent.
Long-short equity, by far the biggest category of hedge fund in terms of sheer number of funds, actually fared relatively well: Hedge Fund Research’s HFRI equity hedge index was down 26.16 percent on the year, compared with the 37 percent drop in the Standard & Poor’s 500 index. “Relatively well” isn’t enough, however. Investors would’ve done better last year going whole hog into cash.
A sinking market wasn’t the only hazard the sector faced in 2008. At the height of the market panic, regulators around the world imposed restrictions on short-selling. And the credit crisis prompted major institutional investors to curtail or even drop their stock-lending programs altogether, making it harder and costlier for short-sellers to borrow stock.
Yet Luca Mengoni, chief investment officer for the single-manager division at London-based Pioneer Alternative Investments (which reported $5 billion in assets under management on December 31, down from $9.5 billion on June 30), an affiliate of Italian money manager Pioneer Global Asset Management, points out that in periods of exceptional volatility, market prices often deviate far from intrinsic values, which he says gives fundamental long-short-biased managers like Pioneer an edge. Instinct and judgment can make the difference. “Once-in-a-century events are by definition very difficult to model quantitatively,” Mengoni notes.
With so many asset classes looking cheap, Mengoni argues, long-short equity strategies are particularly valuable now. He expects high volatility to persist for some time, which increases the chance that outright long strategies may suffer no matter how cheap the assets appear to be. “A long-short equity strategy is perfectly positioned,” he asserts.
But even when conditions are ideal, long-short investing is tricky.
“If you adjust the returns of long-biased long-short managers for risk, it becomes hard to understand why investors shouldn’t just buy the S&P index,” says Anurag Sanyal, co–portfolio manager at Sequence Capital, a $300 million New York–based long-short equity firm that relies on fundamental research to build its portfolio. Sequence is among the select few long-short firms that were up in 2008 — posting a 4 percent net return. Sequence keeps its net market exposure — its longs minus it shorts — to no more than 10 percent of its portfolio’s total asset value.
Most long-short equity managers have a net long bias. But William Knight, co-founder of Pacific Alternative Asset Management Co., a $9 billion fund of hedge funds based in Irvine, California, says the composite portfolio of Paamco’s long-short managers has a net market exposure that varies over time — from 20 percent to 40 percent — rising when the market goes up and shrinking when it falls.
It’s a dicey game. Among those who suffered in 2008 were well-known long-short firms like Lone Pine Capital in Greenwich, Connecticut, New York–headquartered Maverick Capital (its flagship fund was down about 28 percent through mid-December) and Greenwich-based Tontine Associates, which pulled the plug on two funds after they lost a big chunk of their net asset value in October alone. This was because the three firms had either unusually high net long exposure or unusually poor stock picks last year. Knight stresses that the majority of long-short managers, in addition to delivering higher returns, had lower volatility than did market indexes — precisely what investors should expect from the strategy. And though institutional investors and hedge funds that have cash are sitting on the sidelines until the cycle of liquidations and redemptions runs its course, they won’t stay out of the game forever.
“The stock picker’s time will come again — when the market settles down,” Knight says. “Managers are finding incredibly compelling deals out there. Lots of companies have more cash on the books than their market capitalization. They are trading well below fair value.”
Skeptics remain, however. Marco Battaglia, chief executive officer and founder of Temujin Fund Management, a New York–based zero-market-exposure long-short equity hedge fund firm with about $370 million in assets under management, is among those who question whether long-biased managers deliver what they promise. “The industry in general did a good job protecting capital in the past year by cutting net exposure,” he says, “but it was out of necessity. Their net exposure was driving returns, and it illustrated that, for the most part, they have been selling beta rather than alpha.”
Battaglia — whose Temujin Fund was down 11 percent in 2008 — says long-short managers often hedge a big part of their portfolio using exchange-traded funds, which by definition move with the market, rather than shorting individual stocks, which can actually deliver alpha. Prudence dictates that managers keep short positions smaller than longs because shorts carry bigger potential losses, typically close out quicker and require much more work than longs do. “A fundamental manager has to spend double or triple the amount of time researching the short side relative to the long side to construct a truly market-neutral portfolio,” Battaglia notes.
His firm uses quantitative screening — assessing factors like leverage, profit margins and free cash flow — to narrow choices and then drills into the fundamentals of the most promising equities on both sides of its portfolio. Like most long-short funds, Temujin skews its investments toward a few stocks: The ten biggest long positions typically account for half the firm’s net asset value and may be held for a year or more; the rest of the portfolio runs to several hundred names and turns over about twice a year. Each small position typically represents 50 basis points or less of total assets. Here, Battaglia relies heavily on quantitative analysis rather than deep research. “It doesn’t make sense to study a company in depth if you are looking for 2 percent alpha to play out over a couple of months,” he says.
He argues that the spectacular performance of long-short managers during the 2000–’02 bear market was an aberration. The old-economy value stocks they favored as long positions had been left in the dust during the great Internet boom, and when that bubble burst, managers made a killing by shorting overvalued tech stocks. “It was like shooting fish in a barrel if you were a fundamental long-short manager,” Battaglia says. Now, he adds, “it’s going to be hitting singles and doubles with modest net exposure to get to 15 percent. The current generation is largely untested in being able to do that.”
Sequence Capital, founded in 2005 by Sanyal and his portfolio co-manager, Jennifer Klein, has made money in each of its three years. It focuses on four sectors: retail, business services, technology and industrials. Sanyal and Klein won’t consider a stock until they have tracked the company for at least three quarters; they have followed most stocks in their portfolio for years. In addition to studying financial statements, they create models to forecast future earnings. They talk to management, competitors and the supply and distribution channels and dig up whatever else they can from Wall Street or other sources. Ultimately, it comes down to a three-part assessment. “Some of the research is hard numbers, some is qualitative, and then there’s an element of judgment,” Klein says.
Sequence’s long-short portfolio typically includes 65 to 70 stocks, and its average position size is just over 1 percent of holdings. At least one third of its trades play out over 12 to 18 months, so portfolio turnover is relatively low. The firm’s strategy falls at the low end of the long-short spectrum, where net market exposure can run anywhere from zero to 80 percent, according to Antonio Muñoz-Suñé, who heads the $1.1 billion U.S. arm of EIM, Arpad Busson’s Geneva-based fund of hedge funds. Muñoz-Suñé divides long-short equity managers into three subcategories based on market exposure: those that are up to 60 percent net long, those that are market neutral and a select few managers that vary their bias over time. In today’s especially treacherous markets, Muñoz-Suñé favors the less-common variable-bias breed, which may be as much as 80 percent long or short, depending on market conditions. “Very few people can manage from long to short on a net basis, even though everybody says they can,” he explains. “The majority of long-short equity managers have a net long bias of 20 percent to 60 percent.”
Managers often focus on particular industries or make decisions based on geography. In theory, after all, it’s a stock picker’s game based on buying winners and shorting losers, but Muñoz-Suñé points out that in a massive sell-off like last year’s, the market does not discriminate. He says the directional bias of most long-short equity managers offers little protection in a one-way market, and although they can buy stocks at prices that may be a bargain looking out three to five years, it is pointless to do so if a fund can’t survive long enough to cash in. Recovery is tough when a fund is down 30 or 40 percent, as many “good value pickers” are, says Muñoz-Suñé. A fund that has fallen 40 percent, for instance, has to go up 67 percent just to reach its high-water mark and start collecting performance fees again.
Paamco co-founder Knight says the best-performing managers today combine strong fundamental research skills with aggressive trading. How managers size their positions and when they make a move is critical too. “A number of people who are very good analysts fell down on portfolio management, and it really hurt them in 2008,” Knight notes. “They got whipsawed, and then they started violating other portfolio disciplines.”
Some funds did much better than the indexes last year, and a handful even made money. A multitude of long-short equity managers have proven their worth since 2001, however. In five years during that period, the HFRI equity hedge index beat the S&P 500 index. The period includes not only three years when the S&P was down — when long-short managers ought to outperform — but also five straight years in which the market was up. In two of those five years and over the five years compounded, long-short managers beat the market return even though they had less than 100 percent net market exposure, a clear signal that they delivered alpha to their investors.
In many respects classic long-short equity managers — those who use little leverage and rely on fundamental research — hark back to the original hedge fund, created by Alfred Jones in 1949. Rady Asset Management, a $50 million firm based in La Jolla, California, follows a strategy that bears a striking resemblance to the Jones model. Harry Rady, the firm’s chief executive officer and portfolio manager, describes himself as “an old-fashioned value investor utilizing modern-day techniques.”
What are those techniques? Rady, who says he has been using the same method for 15 years, screens stocks quantitatively and then divides them into three categories: names he would never invest in, ones that could be interesting at the right price and those that warrant further immediate research and include “buy now” picks.
“We believe in buying the best at reasonable prices,” Rady says. “In this environment we get to buy the sexiest companies on the planet.” Last year’s market meltdown has given Rady an opportunity to purchase growth companies he had always deemed too expensive no matter how much he admired them (he declines to name names).
On the short side, Rady looks for stocks that are merely overvalued rather than potential basket cases that could go to zero. The ideal candidate is a blue-chip stock where bulls have seized control and expectations for growth are already baked into the price. “If these companies meet or beat an earnings estimate the stock does nothing,” says Rady. “But if they miss market expectations they go down disproportionately.” His portfolio is typically as much as 80 to 90 percent long, 10 to 20 percent cash and 10 to 20 percent short. Recent volatility and the chance to buy cheap growth stocks have pushed Rady’s portfolio turnover up from its historical average of 30 percent per year, but it’s still comparatively low. Many mutual funds have much higher turnover.
Rady’s long bias pulled him into the red in 2008 — he was down 12.85 percent — but he remains optimistic. “When managers are giving up stocks — because companies are going to miss a quarter or their funds have to meet redemptions — I can build positions in best-of-breed companies,” he says, “It’s exciting. It’s dangerous. But it has created more opportunity than I have ever seen in my career.”
