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Comment: Equity long/short - a solution for the long run

Mike Howard, head of long short equity at Ermitage Group, argues that unhedged long-only equity exposure has served investors poorly and that an equity long/short approach can offer a long-term advantage in terms of alpha capture and smart beta management.

Most of us with a pension fund will need no reminder of the extreme wealth erosion that has been the hallmark of 2008. As at the end of November, the MSCI Europe index had fallen by almost 40 per cent in value over the year to date.

However, despite the dramatic market swings, some hedge funds have been able to capitalise on the changing conditions and make a positive contribution to protecting investor capital. Ermitage's European Absolute Fund is a creditable example of what a long/short equity fund of funds can offer, restricting losses to just 1.4 per cent between January and the end of November.

This year has challenged what many thought they knew about markets and hedge funds. For Ermitage, 2008 simply underlines the long-term advantage that an equity long/short approach can offer, in terms of alpha capture and smart beta management.

One of the old investment management mantras is that equity markets trend up through time. Try telling the Japanese that, when the market recently hit a 27-year low. The S&P 500 also hit an eleven-and-a-half year low at the close on November 21 - and European indices are in a similar position.

We are not saying that developed markets are likely to suffer a Japanese-style malaise, but clearly it is not always a safe assumption that the long-term trend will bail you out. We believe the hedged approach is just a more efficient way of compounding returns through equity market investing over the longer term, with significantly lower risk.

For those targeting long-term growth, it is critical to protect capital when equity markets are most stressed. The key to running an effective fund of hedge funds is understanding when a manager can make money and lose money, and therefore exactly what role the manager plays in your portfolio.

During the second half of 2007 Ermitage reduced its exposure to equity long/short managers with a traditional bottom-up stock-picking style, and increased allocation to more liquid, trading-orientated managers. This meant our investors were better positioned for directionally negative markets with high levels of volatility.

We think of risk in terms of failure to meet return objectives and potential loss. Conventional risk measures such as return volatility often obscure the magnitude of potential or realised losses, because they mistakenly treat changes in market direction as random fluctuation, which in principle can go either way. Investors in the major equity markets have lost 40 to 50 per cent from their peaks last summer. In other words, equity returns have not simply fluctuated - they have fluctuated around a pronounced downward trend.

Looking further back in time, investors tracking the MSCI Europe index since December 1, 1999 would see an annualised loss of 2.58 per cent on their original investment over the term - the trend has certainly not been a friend over this time horizon.

Compare that with Ermitage's European Absolute Fund, which has returned 7.87 per cent annualised over the same period with approximately one-third of the volatility of the MSCI Europe index. Our point is that a well-constructed long/short equity portfolio can capture alpha as well as providing effective downside protection by adapting market exposure, and hence considerably face less 'risk of loss' than long-only equity indices. Or stated more plainly, we think going long equities can be viewed as a one-trick pony.

Some investors believe they can time entry and exit from equity markets, so they don't need the hedge protection. But market timing is a notoriously difficult thing to get right and many people lose their shirt trying. How many people bailed out completely in March 2000, bought aggressively in March 2003 and sold again in July 2007?

For sure, a few people are highly skilled at this, but there is significant risk associated with trying to second-guess the market. Investing at least part of a portfolio in a hedged equity fund reduces the pressure to market-time and increases the potential for absolute returns as the market environment changes.

Ermitage's long/short equity funds are positioned well should deleveraging and the associated irrational price movements continue into 2009. Alongside this, we continue to focus on broadening our allocation to uncorrelated managers that can fulfil a true hedge role in the portfolio. Until the unwinding process is complete, we are unlikely to see a strong fundamental value bid in the markets.

In our view, there are compelling opportunities for traders using a combination of technical and fundamental inputs operating in liquid stocks, who thrive on volatility and irrational price movements. Managers who have been defensively positioned in liquid areas of the market will be well placed to generate alpha on both sides of the book and capitalise on the increasing number of opportunities that are arising.

There is no doubt in our mind that the first half of 2009 will continue to be challenging. Nonetheless, we see this as an opportunity to highlight those with real expertise in manager selection and portfolio construction.

With rates falling globally and equity markets on their knees, institutional investors must now find more predictable risk-adjusted return streams, which means finding additional ways to make absolute returns in less liquid, more volatile equity markets.

Conservative long/short equity portfolios like European Absolute offer a long term solution to these challenges, targeting a premium to cash with an imbedded optionality to capture equity market upside should markets bottom and start to rise again.

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