Long Short Equity Due Diligence

A Great Opportunity for Long Short

We find ourselves today with persistent inflation, a tightening Fed balance sheet, rising rates, and declining asset values. These challenges are what lay the foundation for success with long short.

As we noted in Rising Rates - Been so Long we Forgot What They Were “not all stocks will rise. Some companies will struggle to generate earnings if their balance sheets are not prepared for higher rates.” However, with a long short allocation we think investors may not need to worry about struggling companies. Struggling companies provide an opportunity for long short funds. This is because long short funds maintain short positions in companies poorly positioned to generate  robust earnings. As a result, funds can potentially “significantly reduce downside or gain when the broader market declines.” The allure of this has attracted $21 billion of inflows into liquid alternatives, including long short equity, since the beginning of the year, according to Morningstar.

Picking the Right Fund: Long Short Due Diligence

Morningstar’s long short category, has one of the most diverse set of strategies and consequently returns among the under-lying funds. As advisers and analysts, this creates ample opportunity to add value for your clients’ portfolios. The use of any sort of quantitative risk and performance ranking may be misleading as you are not comparing apples to apples but in our opinion, it is more like fruits to vegetables. As a simple example, in the same Morningstar long short category, you have a domestic manager with close to zero per- cent net exposure and an emerging market only manager with 70% exposure…yet they are being compared and ranked next to each other. Why does this matter? Because the volatility of any ranking scheme would be higher than expected and highly dependent on the market environment. Essentially, there is a higher likelihood that those firms ranked the highest, thus encouraging buyers, would be ranked the highest at precisely the wrong time to be buying. The long short category is a category that requires much deeper analysis than a simple rear- looking cursory, quantitative review. So how should one go about it? Given the challenges of rearward-looking performance comparisons, one must have a qualitative assessment process to narrow down the universe to those funds believed to be structured correctly to achieve the desired goals.

Defining and Recategorizing the Universe

Morningstar has recently moved long short equity from alternatives to the nontraditional equity category. What this means is that Morningstar wants investors to view long short “as part of a diversified portfolio's equity allocation.” In other words, a long short fund’s performance should be compared to other investments within a portfolio’s equity allocation. Given long short’s higher correlation to equity markets and the higher beta relative to other alternative strategies, the team at Long Short Advisors understands Morningstar intent. However, investors must be careful comparing reduced volatility long short strategies to the more volatile general equity markets because long short’s under and outperformance periods will have much more variability. than traditional equity strategies. Morningstar defines the long short equity universe as follows:

Long short portfolios: 

1. Hold sizable stakes in both long and short positions in equities and related derivatives.
2. Some funds that fall into this category will shift their exposure to long and short positions depending on their macro outlook or the opportunities they uncover through bottom-up research.
3. Some funds may simply hedge long stock positions through exchange- traded funds or derivatives.
4. At least 75% of the assets are in equity securities or derivatives.

We have found that this definition can be violated by some strategies (i.e. not all funds short, etc.) and even for all the funds which meet these criteria, there is too much latitude for homogenous comparison. Further still, delineation of the universe is needed. At Long Short Advisors, we have further categorized the universe based on factors including but not limited to the following:

1. Whether or not shorting is used versus the use of cash or bonds for tactical allocation
2. Whether or not individual stocks are used for shorting (rather than ETFs, options, etc.)
3. Whether  or  not  net  exposure  maintains  a  targeted  range  or  is  more dynamic
4. Geography (domestic, international, global, country specific)
5. Market capitalization of stocks in portfolios
6. Actual use of leverage on the long side (greater than 100%)
7. Use of derivatives (i.e. futures, options, etc.)
8. Quantitative vs. fundamental

According to Morningstar, as of May 31, 2022, there are approximately 179 long short funds, but this includes multiple share classes of the same fund. Once we whittle this list down to unique funds, the universe shrinks by about half. One should use the “long short” terminology lightly because not all funds short (as hard as it is to believe). Many funds that do short do not do it consistently, and those that do short consistently do it through not necessarily directly comparable means (i.e. individual company shorts, ETFs, options or otherwise). There are “core” strategies and “satellite” strategies. Investors should expect core strategies to more consistently deliver the returns of the asset class, making them more appropriate for a greater number of investors and at larger relative weightings. Satellite strategies, on the other hand, have the potential for significant outperformance or under- performance relative to the asset class, making them less predictable and less appropriate for all clients. You can of course use both, but you must be careful to know which you are selecting. Upon final due diligence, we at Long Short Advisors believe there are very few core long short strategies represented in the universe and that satellites being mistaken for core is what leads many investors astray and ultimately to frustration. What should investors review when selecting a core long short strategy? (This is, in no way, an exhaustive list.)

At Long Short Advisors we have recategorized every single strategy in the universe and monitor each of them on an ongoing basis in what we believe to be a more appropriate fashion.

For a more exact discussion on our research into the further categorization of the Morningstar Long Short Universe please click here to schedule a call.

15294227-UFD-07/11/2022