Three Reasons Why Long/Short Equity Belongs in Core Allocations

Increased volatility, limited growth opportunities and a low-return fixed income environment are just a few of the reasons advisors are shaking the foundations of investor portfolios and seeking strategies to bolster core allocations.

In investing, the “core” has traditionally consisted of developed-market equities and investment-grade debt. Increasingly over the last decade, investors—both retail and institutional—have sought to diversify that core by adding “satellite” allocations such as commodities, floating rate and high-yield debt, emerging market assets, hedge fund strategies and other diversifiers.

But not all satellites are distinctly different from core assets. Of all of the satellite strategies, the one that most closely resembles the core of a typical portfolio is long/short equity, and therefore can be used to support and strengthen it for three distinct reasons:

1. Long/short equity is a strategy, not an asset class, which invests in equities, and usually does so with net exposure well below 100 percent. That ends up looking quite similar to a combination of equities and cash or bonds.
2. Long/short equity strategies have, on average, matched the performance of equities with essentially the same level of volatility as a 60/40 stock/bond portfolio, and with better downside protection.
3. Long/short strategies may be in greater need today than in decades due to the current uncertain market environment.

A correlation analysis of the returns for equities, as represented by the S&P 500 Index, and long/short equity strategies, as represented by the Credit Suisse Long/Short Equity Index, reveals that from January 1994 through December 2015, equities and long/short equity strategies exhibited a correlation of about 0.7.

As alluded to earlier, this fairly high correlation is expected, given that long/short equity strategies derive the bulk of their return from equity beta, albeit in lesser amounts than long-only constrained portfolios. Further, consider the following risk and return characteristics.

Source: Morningstar Direct 1/1/1994 to 12/31/2015

One can see the performance of long/short equity strategies and how, on average, they’ve matched equities with essentially the same level of volatility as a 60/40 stock/bond. (This occurred over a time period when the yield on the 10-Year Treasury went from 5.75 percent to 2.24 percent, which was unquestionably beneficial to the performance of investment-grade debt.)

But here’s the question: Could even the most astute professional investor determine in advance when such time periods will be more conducive to a 60/40 core than for a long/short equity strategy? Of course not. We are not stating that long/short equity should completely replace the traditional stock/bond core, but rather it could replace a portion of that core by allocating from both equities and fixed income—and potentially improve overall performance, through an increased number of alpha sources, while dampening volatility, among other things.

Given our uncertain world, it seems that now more than ever, long/short equity should be thought of as a core position, not as a minor “alternative”’ allocation floating out amongst the satellites. Over multiple market cycles (including two major crashes), long/short equity strategies have outperformed the 60/40 core on a risk-adjusted basis, and for that reason, coupled with a market environment that portends low future returns, long/short equity strategies undoubtedly belong within the core.

Clifford Stanton, CFA is Chief Investment Officer of 361 Capital and is responsible for managing the investment department, including oversight of strategy development, investment research and portfolio management.