Taking the complexity out of long/short investing

Managers Views
August 14, 2019

Long/short investing allows an investment manager to more efficiently capture the information from their investment process. There are two main advantages to a long/short structure. Firstly, additional returns can be made from shorting stocks that underperform the market. In a long only fund, the ability to outperform by not owning underperforming stocks will be limited by their weight in the index. Secondly, a long/short portfolio can be more diversified than a long only portfolio, avoiding the impact of style bias, while still targeting higher returns.

Diversification of risk and higher return potential with long and short holdings

The ability to beat an equity index benchmark is determined, to an extent, by the composition of that benchmark. For example, if an equities index was dominated by one large stock that comprised 99% of the benchmark weight, then beating that index could only be achieved by holding stocks that performed better than that one large stock. If this large stock was one of the best performing stocks, then beating the index would be extremely difficult. Conversely, if the large stock was among the worst performing stocks, then anyone who was less than 99% invested in that one stock would beat the index. This is the dilemma facing long only equity investors in the Australian equity market, which is dominated by a small group of very large stocks.

When building an investment portfolio, the ability to short companies removes the constraint around index weights. The distribution of weights across the index becomes irrelevant and the investment manager is free to choose portfolio weights for stocks that are independent of the index weight, subject only to liquidity. A long/short portfolio can achieve active return targets with a far more diversified portfolio of stocks. The greater diversification resulting from this can mean a better risk/reward trade-off and more consistent returns to investors over time. This results in a higher information ratio for a long/short style strategy. There is, however, often a higher amount of risk involved in this type of strategy.

Why invest in a long/short investment strategy?

A long/short structure allows flexibility in product design to meet the needs of different investors. There are two main types of long/short structures.

1. Equity long/short or equitized long/short where some stocks are short, but the proceeds are reinvested in long positions to retain exposure to the equity market. This provides investors with exposure to both growth in the equity market as well as enhanced returns from the active management.

2. Market neutral or absolute return where short positions and long positions offset each other. This type of structure gives investors exposure to the manager’s stock selection skills while eliminating exposure to the underlying equity market.

Long/short strategies have gained in popularity over the years as investors have become more comfortable with strategies that involve short selling. The different structures can meet the needs of investor portfolios that allocate to equities for long term income and growth potential or given heightened market volatility and the need for capital protection and yield, provide a source of uncorrelated returns to the equity market.

A differentiated stock selection process

Sage Capital’s stock selection process utilises two complementary sources of return, employing both a quantitative and a fundamental process. The objective of this process is to identify companies that will deliver superior earnings outcomes on an attractive risk/reward basis.

The quantitative process does this by exploiting behavioural biases that exist within the market. These biases mean that investors often misjudge the implications of available information and a consistent application of specific factors, including momentum, value and quality, can drive excess portfolio returns. The fundamental approach identifies companies that operate within stable and attractive industry dynamics with strong reinvestment opportunities, are well managed with strong balance sheets and maintain good governance practices. They will generally be attractively valued for their growth and risk characteristics and offer strong opportunities for capital growth through earnings uplift and enhanced valuations.

The strength of the quantitative process is the objectivity and breadth that it brings to stock selection while the fundamental approach gives more detailed high conviction views. The two approaches are weighted to give a roughly equal contribution to stock selection. This investment process is symmetric, meaning that it highlights poorly performing companies just as often as good ones, which provides shorting opportunities under the long/short structure.

Diversification is a key attribute of the Sage Capital portfolio construction process and a suite of sophisticated risk management tools are employed to ensure that the impact of unexpected risks is minimised.

Who may be suitable to invest in a long/short strategy?

A long/short strategy may be suitable for investors with an investment horizon of 5+ years, who seek capital growth and income through exposure to Australian shares and are willing to accept the shorter term fluctuations in price typically associated with such investments.

In the current volatile market environment, employing a long/short strategy may prove to be a good additional diversifier of your long-only Australian equities exposure.  For more information about this strategy, get in touch with us.