The Limitations of Long / Short Equity Funds

The very first hedge fund was a long/short (l/s) equity strategy created by Alfred Winslow Jones in 1949[1].  Mr. Jones used leverage and short selling within an equity portfolio to create more opportunity for stock picking “alpha” and still control (hedge) the total market exposure.  L/S equity continues to be one of the more popular strategies today, accounting for 50% of the funds included in the Hedge Fund Research Fund Weighted Composite, a rough indication of the total universe of hedge funds. 

Read the article below for more information on Limitations of Long/ Short Equity Funds. 


Strategy Structure

Long/short equity portfolio managers (PMs) search the universe for stocks that they believe will rise or fall and then take long or short positions accordingly.  The funds typically use leverage to increase the impact of the stock picks and thus the potential value added or “alpha” over the market return.  The shorts counteract the levered long exposure and hedge or reduce the impact of market moves on the total portfolio’s return.

These funds tend to have a long bias, or more longs than shorts, in part because markets tend to go up over time and the net long bias provides a tailwind to returns.  A representative model of a l/s equity fund has a long exposure of 120% and a short exposure of -60%.  The total gross exposure is 180% and the net exposure is 60%. 

We note that equity market neutral funds and 130/30 funds are also both long and short equities but they have different exposure profiles.  Both types of funds use leverage to increase their potential “alpha;” however, their net market exposure is zero and 100% respectively.  Thus, the returns to equity market neutral funds, as the name implies, are not impacted by market moves and, conversely, 130/30 funds capture all of the market’s upward drift over time as their net exposure is 100%.

[1] Anson, Mark J.P. (2006). The Handbook of Alternative Assets. John Wiley & Sons. p. 36. ISBN 0-471-98020-X.

Expected returns are using AHIC Q2 2019 10 Year Capital Market Assumptions as of 3/31/2019, which are projections about the future returns of asset classes. For asset classes that can be implemented passively, which includes most public assets, alpha and active management fees are not included in the return expectations.  For asset classes that can only be implemented actively, such as hedge funds and private assets, we assume alpha and higher active manager fees. Expected returns are geometric (long-term compounded). Expected returns presented are models and do not represent the returns of an actual client account. Not a guarantee of future results. See appendix for capital market assumptions disclosure pages.  Data in this document is sourced by Aon unless otherwise stated. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice.  To receive a copy of the methodology used in this analysis please email Chris Walvoord at chris.walvoord@aon.com  Diversification does not ensure a profit nor does it protect against loss of principal. Diversification among investment options and asset classes may help to reduce overall volatility.

Model Fund Return Analysis

Hedge fund investors should develop expectations for not just the expected magnitude of returns but also the volatility reduction and the diversification benefits that come from investing in these complicated and expensive vehicles.  Aon’s capital market assumptions indicate that global stocks are expected to return roughly 7.0% over the next ten years.  This expected market return is multiplied by the l/s equity fund’s net exposure of 60% to get the market contribution to the fund’s return of 4.2%.

The other component of our model fund’s return is the stock picking alpha.  Aon’s analysis of global unconstrained stock funds, both long-only and long/short, indicates that we might expect the very best PMs to generate around 3.0% of alpha per year.  Our representative l/s equity hedge fund uses leverage so we multiply this 3.0% by 180%, the gross exposure, for a total return contribution from stock picking alpha of 5.4%.

The total gross return for this representative l/s equity hedge fund is the sum of these two components, or 9.6%.  Typical fees for a l/s equity hedge fund today are a management fee of 1.5%, expenses of 0.2% and a performance fee of 20%.  This takes our 9.6% gross return down to 6.3% net.

The first thing to note is that even with our assumption of outstanding alpha generation the l/s equity fund is up only 6.3% net while the market returned 7.0%.  Importantly, this underperformance is not due to poor stock selection.  We assumed the manager generated best in class stock picking alpha.  The stock picking alpha was still insufficient to overcome the reduced market exposure and high fees.  The fund cannot keep up in rising markets.

The reduced market exposure makes the l/s equity fund’s return about 60% less volatile than the market.  The alpha component of the return will also be volatile but it should generally be uncorrelated to the market and to other exposures in the overall portfolio.  While the l/s equity fund’s absolute return trails the market, the risk adjusted return, or Sharpe ratio, will likely be better than the market.

The market component of the return stream causes the l/s fund to have a meaningful correlation to equity markets.  This correlation greatly reduces the diversification benefit of a l/s equity allocation within an investor’s overall portfolio.  The incremental equity market risk that l/s funds add must be included when analyzing the total market exposure of the overall portfolio. 

The l/s fund investors typically pay a 20% performance fee on the total return that is roughly half stock picking alpha and half due to market exposure.  Market returns cost only a few basis points when obtained via an index fund.

Conclusions

Investors need to understand the inherent characteristics of long biased l/s equity funds when determining the role of such an allocation within a portfolio.  Performance expectations must consider the impact of the leverage, the net market exposure and the performance fee structure on returns. 

The leverage will increase the impact of the manager’s stock picks.  It allows skilled managers to deliver more outperformance for the same capital allocation, increasing efficiency.

The reduced market exposure of a long biased l/s equity fund is a double edged sword.  It prevents the fund from capturing all of the upward drift of the market but it also reduces the volatility of the return stream.  This reduced volatility, along with the increased alpha from the leverage, should improve the Sharpe ratio of l/s equity funds.  

Finally, most l/s equity hedge funds include a performance fee on both the stock picking alpha and the market component of the return.  The latter is available elsewhere for much lower cost.  Our recommendations are:

  1. L/S equity funds tend to be highly correlated with the equity markets and this incremental market risk must be included in the analysis of a client’s overall equity market exposure.
  2. Investors should not expect these funds to keep up with the equity market over a cycle, even with excellent stock picking results.  They will generally have lower volatility than the markets but also lower returns.
  3. Investors should not pay a performance fee on the market portion of the fund return.

Past performance is no guarantee of future results.  Indices cannot be invested in directly.  Please refer to the disclosures for Index Definitions and other General Disclosures.

Data in this document is sourced by Aon unless otherwise stated. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice.

The fee information presented reflects estimated management fees and excludes any operations or other expenses the client may incur, potential savings which may or may not be achieved. Actual fees and expenses may differ from those presented based on other fees and expenses you may incur as a client. The investment management fees presented above are based on the rate AHIC is able to obtain based on the firm’s volume of assets, and may not be available to individual plan agreements. There is no guarantee that the projected estimated savings will be achieved.

Index Definitions:

HFRI Fund Weighted Composite Index – Equal weighted peer group of self reported returns of hedge funds to Hedge Fund Research

The capital market assumptions (CMAs) utilized in the expected returns data provided in this document were developed by Aon's Global Asset Allocation Team and represent the long-term capital market outlook (i.e., 10 years) based on data at the end of the second quarter of 2019. The assumptions were developed using a building block approach, reflecting observable inflation and interest rate information available in the fixed income markets as well as Consensus Economics forecasts.  Our long-term assumptions for other asset classes are based on historical results, current market characteristics, and our professional judgment. Expected returns are using AHIC Q2 2019 10 Year Capital Market Assumptions as of 3/31/2019. CMAs contain projections about future returns on asset classes. These do not assume additional alpha for active management strategies within these asset classes, and are modeled to represent a low nominal fee passive index, with the exception of hedge funds and private equity, where traditional passive investments are not available. Therefore, the model assumptions for hedge funds and private equity strategies include a higher model fee impact for these asset classes.  You cannot invest in an asset class directly, or within the model asset classes assumed within the CMAs. CMAs do not include asset class fees or any underlying expense ratios. Expected returns are geometric (long-term compounded; rounded to the nearest decimal). Expected returns presented are models and do not represent the returns of an actual client account. Not a guarantee of future results.

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