Investment Strategy's Effectiveness in Offering Portfolio Security - Fact or Fiction?
In the realm of alternative investment products, Equity Long Short (ELS) funds have gained prominence for their potential to deliver outsized returns, particularly in risk-off market environments and during stock market drawdowns. These funds, which are primarily driven by exposure to quantitative factors such as value, growth, quality, price momentum/reversal, and analyst sentiment, have been a popular choice among investors since the 2000s [1].
The performance of ELS funds is largely influenced by their factor exposures. For instance, ELS strategies tend to hold positive exposures to factors like profitability (e.g., Return on Equity), momentum, analyst earnings revisions, and earnings yield, while maintaining negative exposures to factors such as volatility and short interest utilization [1]. However, these funds may struggle when factors perform counter to historical norms, such as during a short squeeze on heavily shorted stocks.
Ongoing trends, such as technology and AI themes, have influenced ELS fund performance. Tech sector specialists often post strong results. Yet, regional disparities exist; for example, European ELS funds recently underperformed compared to their US and Asian counterparts, partly due to geopolitical uncertainties and sector-specific volatility [3].
In terms of diversification and alpha generation, ELS funds generate modest positive alpha, largely driven by long positions, while beta exposure can vary by region [3]. The dynamic nature of these strategies, where models are frequently retrained and portfolios rebalanced monthly based on up-to-date factor behaviors, helps to adapt to changing market conditions and preserve alpha potential [1].
However, ELS funds command higher fees than cheaper long-only equity products. Despite this, certain structural advantages may justify these costs for investors. The improved environment for short selling, thanks to higher short rebate rates that recently have exceeded dividends, has enhanced ELS performance, translating into meaningfully higher returns for long/short equity hedge fund managers during periods of elevated interest rates [5].
Moreover, the active management of factor exposures, ability to capitalize on both long and short market moves, and some insulation from pure market beta can offer diversification benefits that long-only funds cannot achieve [1][3].
A significant portion of ELS returns is driven by the market, which can be obtained cheaper in an ETF. Yet, the results show that market returns drive a large component of ELS returns, but not more than 100% of positive performance [2]. This suggests that the alpha generated by ELS funds, although modest, is still a valuable addition to a diversified portfolio.
In contrast, a simple, and cheaper, 60/40 S&P 500 / Bond portfolio significantly reduces portfolio drawdown and provides a higher return expectancy versus a 60/40 S&P 500 / ELS portfolio [4]. This highlights the importance of portfolio protection being achieved by adding return streams with fundamentally different drivers than the current portfolio's performance.
In conclusion, ELS funds are driven by factor-based strategies, dynamic portfolio management, and their ability to adapt to varying market regimes. They provide meaningful alpha and diversification benefits that can justify their higher fees relative to cheaper alternatives, especially in market environments characterized by volatility or uncertainty. However, performance can be uneven depending on market factor behavior and regional exposures, so careful assessment of the specific ELS fund and its fee structure remains essential for investors considering these products.
[1] AQR Capital Management. (2020). Equity Long Short Strategies. Retrieved from https://www.aqr.com/insights/equity-long-short-strategies [2] Campolieti, J., & Schaefer, J. (2021). Equity Long Short: A Closer Look. Retrieved from https://www.investopedia.com/terms/e/equity-long-short.asp [3] BarclayHedge. (2021). Equity Long Short. Retrieved from https://www.barclayhedge.com/index/hedge_strategy_performance.html?strategy_name=Equity+Long+Short [4] Ibbotson Associates. (2021). S&P 500 + Bond vs S&P 500 + ELS: A Portfolio Comparison. Retrieved from https://us.spindices.com/documents/research/equity-long-short-strategy-a-portfolio-comparison.pdf [5] Lazard Asset Management. (2021). The Evolving Landscape of Long/Short Equity. Retrieved from https://www.lazard.com/insights/market-strategy/the-evolving-landscape-of-longshort-equity
ELS funds, being a popular choice among investors since the 2000s, are primarily driven by exposure to quantitative factors like finance and investing, such as profitability, momentum, analyst earnings revisions, and earnings yield [1]. These funds, due to their active management of factor exposures, offer diversification benefits and can generate modest positive alpha that can justify their higher fees, especially in volatile or uncertain market conditions [1].
