Many of the traditional sources of diversification are struggling in the current market environment. Nevertheless, long short equity funds could offer an alternative.
To say that 2022 has been a difficult year for investors would be an understatement. What’s particularly weird about this year is the fact that traditional diversification options haven’t worked out. Diversifiers such as 60/40 equity/bond portfolios, defensive assets (such as consumer staples, real estate, utilities), new assets such as cryptocurrencies, and even gold have failed to protect investors from the losses.
Something similar happened in the global financial crisis of 2008, and again briefly in March 2020, when global lockdowns triggered a liquidity shock and a collapse of financial markets. This phenomenon usually only occurs in severe crises, so it is expected to be a very rare event.
The chart below for the US shows how rare it is for both equities and bonds to fall together.
And the chart below gives an indication of how rare it is for 60/40 portfolios to suffer significant losses. The 2022 figure is annualized, making the decline so far this year seem more extreme.
Rate hikes from ultra-low levels exacerbate market distortions
What strikes us about the current broad market correction, except for the US dollar (even commodities are taking a hit lately), is the duration of the current dislocation in sovereign bond markets. The fall in global public debt is the largest in annualized terms since 1865, according to Bank of America, and can be directly attributed to the level we started from due to the zero interest rate policy (ZIRP). In the US, during the great financial crisis, the 60/40 US Index fell for nine months, but this was mainly on the equity and corporate bond side. Right now we have been falling for seven months, without a truce.
Apart from the rate policy, what also differs from the great financial crisis is that inflation is much higher. Central banks are draining liquidity, rather than flooding the markets with it, as the quantitative easing experiment is perhaps coming to an end. For this reason, we find it difficult to assume that this challenge to the efficient market hypothesis (ie, that asset prices reflect all available information) is over.
“Cash is king” is a term often used in bear markets, and it is often valid. The problem today is that the return on cash after inflation is currently extremely negative and inflation has already reached high single digits in the western world.
Long short funds can limit market exposure
It is in difficult market environments like the current one that long-short equity hedge funds can be a good diversification option. Of course, hedge funds haven’t outperformed traditional 60/40 portfolios in the past during bull markets. But the comparison must take into account risk-adjusted return, preservation of capital in periods of stress, and minimal correlation.
Long short equity fund benchmarks are often based on cash rates, unlike other risk asset benchmarks. This is the case for low net worth/market neutral strategies that have limited beta, or market, exposure. The last bull market was also a period in which interest rates fell systematically and liquidity was abundant, distorting the risk-return relationship of bonds and some parts of the equity market (such as high-tech tech stocks). increase).
The world and the markets have changed radically since the end of 2021, when central banks, unfortunately belatedly, began to react to inflation. Looking ahead, investors like us find it difficult to find parallels to the current situation (war, inflation, interest rate hikes, oil shocks) in our investment memories.
At first glance, the era of early 1970s stagflation and Federal Reserve tightening is the closest comparison. Even in that period, government bonds performed well in nominal terms, with most of the losses in the 60/40 portfolios being borne by equities.
Long short equity strategies are pretty straightforward in many ways: they go long on assets they like and short on ones they don’t. The world of hedge funds is a very diverse asset class that encompasses various products and risk profiles. Low net long short equity hedge funds typically offer less risk than their long-only counterparts with a fraction of the volatility. This is because they can use derivatives to short both individual stocks and indices, the latter through index futures or options.
However, many long-short hedge funds have assumed considerable market risk (beta), which is why some strategies do not hold up in the event of sharp market declines. Therefore, we favor a low net strategy, which limits the market risk a manager can take and therefore allows for both market downside protection and limited correlation.
Opportunities to minimize risk
Another advantage of long short equity strategies is that risk factors such as sectors, factors, etc.) can be minimized. For example, predicting the price of oil and the path of commodity-related stocks is especially difficult right now. It involves understanding the length of the Russian-Ukrainian war and/or the future state of the Chinese real estate market, and essentially predicting geopolitics. A long short hedge fund manager can minimize this portfolio risk by simply not taking long or short exposure to commodity stocks.
Risks that are simply too difficult to predict – or honestly beyond a fund manager’s experience – can be avoided by focusing risks in areas of greater expertise.
We have entered a new regime in the financial markets, unlike anything in the last 20 or even 30 years. With high inflation, the unpredictability of wars and pandemics, and in a world with high levels of absolute debt relative to GDP, one can expect continued volatility and periodic failures of some of the diversification tools on which it relies. modern portfolio theory. Long short net hedge fund managers may offer something different.