If you are a funds buyer, asset allocator or investment officer thinking about the sort of hedge funds that should be in the client's portfolio, here is a guide charting the world of long/short hedge funds. It shows the most important characteristics to examine and take into account before signing on the dotted line.

Hedge funds that ride up on market gains and seek to offset downside risks by shorting are, for rather obvious reasons, getting fresh love from investors after the extraordinary market gyrations of recent weeks. (It remains a source of astonishment to some that while the underlying economy has been blasted by COVID-19, major stock market indices are well off their spring lows.) In such an environment, wealth managers, private banks and family offices must scan the menu options for all the long/short hedge funds out there. How to choose and avoid getting a bad case of indigestion? To explain how investors can make a smart choice is Don Steinbrugge, CFA, founder and CEO of Agecroft Partners (more details about Don below). We hope these insights are useful; readers are most welcome to jump into the conversation. The usual editorial health warnings about views of outside contributors apply; we are grateful to Don for his insights here. Email the editors at tom.burroughes@wealthbriefing.com and jackie.bennion@clearviewpublishing.com
 
There has recently been increased interest in long/short equity strategies after strong relative performance in the first quarter of 2020 relative to equity indices and the perception that the recent sell-off and rebound in the marketplace have created an environment for long/short equity managers to excel. This is great news for approximately 25 per cent of the hedge fund industry that focuses on the strategy after a decade-long decline in the percentage of total hedge fund industry assets. 

For investors looking to hire a long/short equity manager, it can be a daunting task narrowing down the thousands of funds focused on the strategy. Initially, investors focus on the typical evaluation factors for a hedge fund which include the quality of the organization, investment team, portfolio construction and risk controls such as management of net exposures and position sizes of longs and shorts, and quality of service providers. In order to increase the odds of identifying a manager who will outperform, investors should also focus on three high-level areas:

-- The relative valuation of the segment of the equity market in which the manager specializes;  
-- The level of inefficiencies in these markets; and
-- The manager’s ability to gain an information advantage and capture these inefficiencies.

Relative valuation of markets. Many long/short equity managers specialize within the global equity markets in certain areas ranging from geography, market capitalization, sectors, to value versus growth styles. These areas may include a single country like the US, China or Brazil, a region like North America, Europe or Asia, developed markets versus emerging markets, small/mid-capitalization versus large capitalization, or sectors such as technology, healthcare, consumer and energy.

Most managers run a long-biased portfolio with the average net exposure around 50 per cent long. This results in a high correlation in performance to the area of stocks in which they specialize, and a meaningful portion of their performance driven by the beta to those stocks. Therefore, comparing performance across long/short equity managers is not a good indication of their relative quality. Instead, it is beneficial to consider the following: 

Create a custom benchmark for each manager. Various components of the global equity markets perform differently year-to-year. In order to determine if a long/short equity manager is adding value, their exposure-adjusted performance should be compared with a custom benchmark based on the part of the equity market in which they specialize. For example, a long/short equity manager focusing on small-cap US growth companies with an average net exposure of +60 per cent should be compared with 60 per cent of the Russell 2000 growth index. This is something that long only investors have done for years, but has been used much less frequently in the hedge fund industry.

Determine whether managers are biased to outperform. Investors should focus on long/short managers that are concentrated in the most undervalued areas of the global equity markets. This process begins with reviewing historical relative price-to-earnings ratios for different parts of the market such as small-cap versus large-cap growth versus value, developed markets versus emerging markets, and the US versus China. These ratios are then compared with their current levels to determine which part of the equity market seems to be relatively undervalued from an historical perspective. The next step is to try to identify if there are any changes in relative expected earnings growth rates across each of the areas evaluated that would have caused changes to relative valuations.

Over long periods of time, temporary pricing distortions develop among different areas of the market which eventually reverse. This causes a rotation of outperformance for these various areas. Over the past century, the market has consistently overpaid for earnings growth and large-cap stocks, which has resulted in long-term outperformance of value and small-cap stocks. This performance trend has reversed itself over the past decade. This reversal has created an environment where value and small cap stocks are trading at valuations levels near their all-time lows relative to growth and large-cap stocks. The question is, has the world changed or will we see a huge snap back in the performance of small-cap and value stocks? 

Level of inefficiencies. Inefficiencies in security pricing are highly correlated to the size of a company’s market capitalization, the amount of Wall Street analyst coverage, the percentage of stock owned by institutions, and the complexity of the business. The greater the level of inefficiencies in security prices, the higher the potential divergence between market price and intrinsic value, and the more opportunity for investors to generate alpha through security selection. Investors should consider paying hedge fund fees to managers who are likely to earn them by delivering alpha-driven returns to their investors. This is most likely to come from managers who specialize in less efficient areas of the market. For the parts of the market with the most efficiently priced equities, investors would do best to allocate through long-only, low fee investment vehicles.

Information advantage. Investors should only invest in hedge funds where the manager can clearly state what inefficiency in the market they are taking advantage of, and what their differential advantage is in capturing this inefficiency through their investment process. There are many ways that long/short equity managers try to get an edge, with a few being much more successful than others. 

Some of these include:
1. Food chain analysis
2. Focusing on catalysts/events (corporate spin off, new management)
3. Greater expertise in a sector or region
4. Pattern recognition
5. Big data and analytics “arms race” for alpha
6. Fundamental analysis
7. Quantitative

It is also important to understand what a manager is doing differently on the short side of their portfolio. Investors find managers with demonstrated skill in security selection and execution on the short side of the portfolio to be adding substantial value. Some managers do not actively short individual stocks, and may use cash or equity market indices to broadly hedge their portfolios. Other managers who are actively shorting individual equities may do so in a couple of ways: pair trades that directly hedge a portion of the portfolio, or alpha shorts where their main objective is to generate profits. Most managers tend to use a shorter time horizon for shorts, given the expense of shorting due to the high cost of borrowing some of the more crowded stocks. They also tend to have smaller positions, due to the inherent unlimited downside of short positions. 

Summary
The long/short equity manager universe is highly fragmented. Investors can increase the probability of achieving higher returns if they focus on managers concentrating in the relative undervalued segments of the equity markets, along with areas of the market with greater inefficiencies. Managers should be selected that can clearly articulate their ability to gain an information advantage and capture market inefficiencies and whose skill can be quantified by outperformance of a customized benchmark.

About the author
Don Steinbrugge is the founder and CEO of Agecroft Partners, a global hedge fund consulting and marketing firm. He frequently writes white papers on trends he sees in the hedge fund industry, has spoken at conferences and is regularly quoted about the industry, appearing in print, and on TV and radio. He is chairman of Gaining the Edge-Hedge Fund Leadership Conference. All profits from the conference are donated to charities that benefit children, which total over $2 million since 2013. Steinbrugge was a founding principal of Andor Capital Management where he was head of sales, marketing, and client service and a member of the firm’s operating committee. He was a managing director and head of institutional sales for Merrill Lynch Investment Managers (now part of Blackrock). Prior to this, Steinbrugge was head of institutional sales and on the executive committee for NationsBank Investment Management (now Bank of America).