Sep. 1, 2021
Insight Series – Comparing Hedging and Options Strategies
A long/short investing strategy is constructed by initiating a long (buy/hold) position in one or more securities that is expected to appreciate over a specified time while simultaneously initiating a short position in one or more securities that are expected to decline in value over a specified time. The objective is to seek to minimize market exposure while profiting from gains in the long positions, along with price declines in the short positions.
In most circumstances, the drivers of returns in a long/short strategy will be at the individual stock level. The whole value proposition of long/short strategies is that a portfolio manager should be unconstrained and profit not only from investing in stocks he likes but also profit from shorting stocks he dislikes. Whether or not the portfolio manager is any good at identifying those individual winners and losers, as well as the timing of those investment positions taken, will ultimately determine the success or failure of such a strategy.
That said, it is common for long/short strategies to have certain biases reflected in their portfolio. These biases might involve valuations, sectors, capitalization, or any other type of quantifiable factors. For example, if a portfolio manager is fundamentally a value investor, one would likely see value names held long and growth stocks shorted. This kind of portfolio would be doubly exposed to its factor bets, which is great if the factor is in favor but potentially disastrous if it is out of favor.
As any sophisticated analyst knows, return and risk are two sides of the same coin: if the returns of a long/short fund are driven by the portfolio manager’s stock picks, so will be the risks. The portfolio manager will live or die on their ability to identify in advance the individual winners and losers.
If the portfolio reflects a certain factor bias, that bias could help or hurt depending on whether or not it is in favor. To return to our previous example, imagine a portfolio manager has a value bias. A long-only value portfolio will trail the market in a year when growth is in favor, like 2017 or 2015. However, the long/short value manager who is long value stocks and short growth stocks would be doubly exposed to such a factor bet.
Because portfolio managers are unconstrained in a long/short strategy and can essentially double their bets, the performance across long/short funds varies widely. The dispersion between “first and worst” can be quite wide. It is dangerous to use “the average long/short” fund as a proxy for the asset class when the returns and risks are so divergent.
The table below illustrates this:
Source: Morningstar Direct, Zephyr StyleADVISOR. Annualized return, beta, and R2 were calculated vs. the S&P 500 and only for those 187 funds with a three-year track record as of 6/30/21.
While the dispersion in performance is wide, long/short managers do tend to share certain tendencies. Long/short managers tend to have higher than average expense ratios and trade more frequently. According to Morningstar, the median long/short manager has an annual turnover ratio of 163%, and the most active fund has an eye-watering turnover ratio of 7,042%. It is fair to say an investor must have a lot of faith in that particular manager’s process in order to justify a turnover ratio of 7,042%.
It is often said that alternatives perform one of two roles within a portfolio: they are either “alpha drivers” or “beta reducers.” Depending on the individual long/short manager, they can fill either role.
In the previous table, we saw how the sensitivity to the market, as measured by beta and R-squared, varies widely from fund to fund. These numbers should help an analyst or investor determine which role an individual long/short manager might play within a portfolio.
Compared to the typical long/short manager, the Defined Risk Strategy (DRS) approaches the market from the opposite end of the spectrum. While the overall goal is roughly the same—to produce respectable absolute returns through bull and bear markets—the way they seek to accomplish that goal is completely different. One of the fundamental precepts of the DRS is that it is difficult, if not impossible, to identify those stocks that will outperform or underperform on a consistent basis. In contrast, a long/short fund’s entire value proposition is based upon investing long outperforming stocks and shorting underperforming stocks.
The DRS seeks broad market exposure, utilizing broad and liquid ETFs to gain robust coverage of an asset class. Risk is managed utilizing broad-based options on those same asset classes. The DRS’s primary drivers of returns are its buy-and-hold market exposure, its hedging, and its premium collection. All three of these components are at an asset class level and are designed to provide value in different types of markets (i.e. rising, falling, or flat, respectively). The DRS can be described as a “top-down” manager whereas a long/short approach is the epitome of a “bottom-up” style.
Because the value propositions of a typical long/short manager and the DRS are so fundamentally different, a case could be made for pairing the two together. The two strategies approach investing in such different ways that they could form a complementary partnership. Specifically, a long/short fund with more upside market capture and higher beta could be a nice potential candidate for pairing with the DRS, since the DRS has traditionally been used in a risk-reducing role. This would be an example of combining an “alpha driver” with a “beta reducer.”
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Marc Odo, CFA®, FRM®,CAIA®, CIPM®, CFP®, Client Portfolio Manager, is responsible for helping clients and prospects gain a detailed understanding of Swan’s Defined Risk Strategy, including how it fits into an overall investment strategy. Formerly Marc was the Director of Research for 11 years at Zephyr Associates.