Equity market dispersion a favourable backdrop for long-short hedge funds

In the six-year bull market since the financial crisis, investors have focused mainly on returns, enjoying the extraordinary low levels of volatility induced by central banks’ expansionary monetary policies.

But with the end of quantitative easing in the US, the Fed eyeing a rate hike, and markets adjusting to a cycle of a stronger US dollar, ‘V-shape’ movements are expected to continue or exacerbate. Financial market volatility soared into year-end, led by a steep decline in oil, euro currency weakness and sharp drops in both the Russian rouble and equity markets.

Protecting portfolios from downside risk is assuming a central role again.

Hedge funds, traditionally seen as diversifiers in portfolios for their declared ability to produce uncorrelated returns and dampen portfolio volatility, lagged both fixed income and equities over the past few years, struggling with lack of dispersion across markets and asset classes. Today they are back on investors’ radars and last year’s record inflows bear testament to that. Investors allocated $3.6bn (€3.2bn) of new capital to hedge funds globally in the last quarter of 2014, bringing the full year of inflows to $76.4bn, the highest yearly inflows since 2007, according to HFR. (see chart).

Source: Hedge Fund Research

“Post 2008, investors have not got paid to hedge or reduce their long exposure, but history tells us that the time investors stop focusing on risk is the exact time when they should begin focusing on it,” states Lee Levy, founder of San-Francisco based boutique Canid Asset Management, a multi-strategy long-short equity hedge fund.

Divergent macro-economic trends in 2015 are likely to be a significant source of dispersion in equity markets, providing managers with stock and sector-level opportunities. This is a favourable backdrop for hedge funds, including long-short strategies.

Investors should include in their portfolios managers who are able to go short on stocks, and play the market dislocation caused by the fall in oil prices, for example.

The focus should be on those “that truly hedge, and not ‘leveraged beta’ plays,” states Mr Levy, warning investors should not hold unrealistic expectations on returns. “No fund can protect against every decline, they need to protect against the largest decline.”

When considering long-only versus long-short equity investments, investors need to keep in mind the depth of previous falls and the time it took for their long investments to recover those losses.

“The ‘right’ long-short funds reduce both the depth and the time of the declines,” claims Mr Levy.

However, asset allocators complain the majority of so-called long-short strategies are in fact long-biased.

“Most long-short strategies tend to be greatly correlated to equity markets, as seen in the past four to five years, as it is hard to make money on the short side,” says Arnaud Gandon, CIO of Heptagon, a London-based wealth manager.

“Very few managers are willing to have a significant short book, because they are either afraid or have not got the skills or the conviction. And this is particularly true when the market rises,” says Mr Gandon.

In policy-driven markets, it has been difficult to generate consistent returns on the short side, observes Andrew Lee, head of alternative investments in CIO Wealth Management at UBS, but as markets become less liquidity-driven and dispersion increases, it should become easier.

Also, higher interest rates should create additional differentiation across markets, sectors and individual names, based on sensitivity to leverage, thus providing short-sellers with another opportunity to generate returns, states Mr Lee.

Robert Christian, head of research at US-based K2 Advisors also believes that increased dispersion will support short-sellers. “There is a big opportunity to make money on the short side going forward, and we have been specifically looking for those types of managers, with deeper dive research and higher convictions.”