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© Copyright 2000 Rogers Media. The following article first appeared in the April 2001 edition of
BENEFITS CANADA magazine.
Hedged equity--the long and short of it
Long/short equity and equity market neutral hedge fund strategies offer reduced exposure to equity
markets and low correlation to traditional asset classes.
By Robert Parnell
The hedge fund industry certainly isn't short of innovations. Two strategies that have much in common are
long/short equity and equity market neutral. Hedge funds focused on long/short equity represent almost 50% of
total hedge fund assets or US$175 billion to US$250 billion, whereas equity market neutral is a much smaller
niche strategy with fewer hedge fund managers and assets devoted to it.
In both approaches, hedge fund managers purchase a basket of stocks that are considered relatively cheap
(long positions), while simultaneously short selling a basket of stocks that are relatively expensive
(short positions). The main difference between these strategies is the degree to which the portfolios are
hedged.
Long/short equity hedge fund managers can, and often do, maintain net market exposures. On the other hand,
equity market neutral hedge fund managers go to great lengths to balance the long and short positions to
ensure zero or negligible market exposure. In a short sale, the hedge fund borrows stock from its prime
broker and sells it in the market in the hopes of buying it back at a cheaper price in the future. An ideal
short trade will see the stock price fall precipitously. The hedge fund will then buy it back, make good on
its obligation to return the borrowed stock, and pocket the difference.
Despite its somewhat speculative reputation, short selling in the context of a hedge fund strategy can
actually lower total portfolio risk. Short positions can decrease net exposure to the stock market and, as
a result, reduce market or systematic risk. Since most of the risk in a long stock portfolio is systematic,
adding short positions can be a potent risk reducer.
In an equity market neutral hedge fund portfolio, the only residual risk is security specific. And since
security-specific risks diversify effectively, shorting can help to create portfolios with low levels of
return volatility.
In a hedged equity portfolio, the overall direction of the stock market is less important than in a
traditional equity portfolio. What matters is that the long basket outperform the short basket on a
relative basis. However, a hedge fund can profit even if both the long and short positions decline in
absolute terms.
Provided the long basket declines less than the short, gains on the shorts will exceed losses on the longs.
Conversely, in a rising market, a hedge fund can profit if the long stocks appreciate more than the shorts.
In this framework, hedge funds have the ability to perform well in both bull and bear markets.
Some hedge fund managers use purely quantitative factor-driven models, while others use more qualitative or
judgmental approaches. Fundamental value analysis is common to hedge fund portfolio management as it is in
traditional long-only investment strategies. But the hedge fund manager is also able to use fundamental
analysis to capitalize on overvalued and undervalued situations.
Many hedge fund managers focus on a specific industry while other funds may have a large-cap or small-cap
focus, or a particular geographic niche. In the market neutral category, managers create portfolios that
are more perfectly hedged with respect to overall market factors. For example, portfolios can be hedged
with respect to dollar exposure with an equal dollar value of securities purchased long and sold short. As
more factors are hedged away though, the opportunity for the manager to add value is reduced. A perfectly
hedged portfolio should produce a risk-free rate of return minus transaction costs.
Pairs hedging is one form of equity market neutral style. In this category, managers try to identify pairs
of securities within a sector that are relatively mispriced and take a long and short position.
Statistical arbitrage is another type of market neutral hedge fund strategy. It is a more quantitative
approach to pairs hedging where the manager exploits temporary deviations relative to stock prices. Within
certain industry sectors, pairs of stock prices often have a high degree of correlation and track each
other closely. These prices diverge and converge according to a relatively normal distribution.
When extreme divergence takes place without any fundamental value explanation, managers are able to exploit
the opportunity by taking long and short positions that will profit from price reversion.
There are important differences between the sources of return in a traditional long equity portfolio and a
long/short or equity market neutral hedge fund. In a traditional investment portfolio, returns are derived
from the market's overall return and the manager's value added.
In a typical equity hedge fund portfolio--be it long/short equity or equity market neutral--short stock
positions significantly reduce the market's contribution to the return. In other words, managers get less
of a free ride on the long-term success of the market. A greater percentage of hedge fund returns are then
created by the manager's security selection or ability to time the markets. Often this alpha is magnified
by leveraging the long and short positions.
Over the seven-year period ending Dec. 31, 2000, long/short equity and equity market neutral hedge funds
performed relatively well on an absolute and risk-adjusted basis. The Credit Suisse First Boston
(CSFB)/Tremont Long/Short Equity Index (an asset weighted benchmark of long/short equity hedge funds),
produced an annualized net return of 16.04% with a volatility of 12.65%, while the CSFB/Tremont Equity
Market Neutral Index produced a net annualized return of 11.84% with a volatility of 3.44% (see "Returns of
the day," page 67).
Not surprisingly, both of the hedge fund indexes had a relatively low correlation and beta with the
Standard & Poor's (S&P) 500 composite index (the majority of equity-based hedge funds are still
U.S. market centred.) The use of short selling reduced market exposure, so the relationship to the overall
markets was reduced. In the case of both strategies, a significant percentage of total return was
contributed by active investment management style. This is evident from the relatively high alpha for each
strategy.
Over the past seven years, the alpha for long/short equity hedge funds was 6.05% and the alpha for equity
market neutral hedge funds was 9.65%. The scale of each alpha is surprisingly high--particularly when one
considers that alpha in the traditional U.S. equity category has, at times, been elusive.
The 14.99% net return for equity market neutral hedge funds last year is certainly noteworthy during a year
in which the S&P 500 declined 9.11% and the Nasdaq tumbled more than 35%. As stock selection is the
only major source of return in this strategy, it's clear that managers were able to take significant
advantage of a market that was run mad with excess--both positive and negative.
For their part, equity market neutral managers were able to add value consistently throughout last year.
While the S&P 500 fell eight out of 12 months, the CSFB/Tremont Equity Market Neutral Index produced
only one modestly negative return in September of -14 basis points.
Comparing equity market neutral and long/short equity hedge funds against the S&P 500 illustrates the
differences between both strategies (see "Measuring market sensitivity," page 65). Equity market neutral
hedge funds are almost completely insensitive to stock market direction. However, long/short equity hedge
funds, on average, maintain a net long exposure and therefore have a higher beta.
It's worth noting that the correlation between equity market neutral and long/short equity hedge funds has
been a low 36.7% over the past seven years. This explains why a number of institutional investors have
chosen to combine both hedge fund strategies in a diversified portfolio.
SUCCESS FACTORS
Several key structural factors have contributed to the success of hedged equity strategies. The ability of
hedge funds to take short positions as well as long positions is a significant advantage as it enables the
manager to profit from the large number of fundamentally overvalued stocks in the market.
The universe of potential investments for the manager is essentially twice that of traditional managers. As
most traditional investment managers are prohibited from going short, this is arguably an area where more
inefficiencies exist.
Although most managers have a strategy specialization, their funds are typically characterized by few
investment policy constraints. This allows the manager the flexibility to be less than fully invested
during certain periods, and concentrated in a particular security--discretion that many traditional fund
managers simply do not have.
The lack of investment policy constraint is clearly a double-edged sword--it subjects the hedge fund
portfolio to greater manager risk, but at the same time gives the manager greater discretion to outperform.
There is no doubt that a key factor in the success of hedge funds has been the limited size of their assets
under management. The vast majority of managers still have less than US$1 billion under management and many
hedge funds have between US$200 million and $800 million. While the importance of size as a predictor of
success has often been debated with respect to traditional investment managers, in the hedge fund business
there is little doubt that smaller is better.
The recent demise of Julian Robertson's Tiger organization and the capitulation of George Soros's Quantum
fund is anecdotal evidence that monolithic hedge funds like these struggle to perform. Management skill
within a hedge fund structure is simply not as scalable as traditional investment management.
This, of course, is why hedge funds charge performance-based fees. Where investment management skill is a
scarce resource and capacity is tight, performance-based fees are not only necessary, but inevitable.
Performance fees provide a significant incentive to managers and may, in part, explain why equity-based
hedge funds have produced such attractive alphas.
With good risk-adjusted returns, low correlation and relatively high alpha, long/short equity and equity
market neutral hedge funds appear to offer numerous advantages to pension funds and other institutional
investors. Overall, these hedge fund strategies give investors the prospect of higher alpha in an asset
class where beating the benchmark index with any consistency has been difficult. And as witnessed last
year, hedged equity strategies have the potential to produce a positive return in a negative market
environment.
Robert Parnell is president of Tremont Investment Management Inc. in Toronto. This article is the third in
a series on alternative investing. rparnell@tremontinvestment.com.
*** ***
Measuring market sensitivity
Equity market neutral hedge funds are strictly hedged and designed to have negligible net market exposure.
They have low betas or low levels of market sensitivity. Although only partially hedged, long/short equity
hedge funds typically have residual net long market exposures as well as greater market sensitivity.
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