April 14, 2009
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Many advisors believed diversified long-only portfolios would always serve their clients well, regardless of the market conditions. They expected certain asset classes would perform well even as others struggled. Unfortunately, many have learned hard lessons over the past year and a half, as virtually all classes have declined in value, causing sizable losses to their clients’ (and their own) portfolios.
“This environment has exposed the flaws in traditional asset allocation theory, the Capital Asset Pricing Model (CAPM), or whatever label you choose to put on it,” said Tom Samuels, managing partner of Houston-based Palantir Capital Management and manager of the Palantir Fund, a global all-cap long-short mutual fund. “While (Harry) Markowitz and (William) Sharpe still have their firm believers, sophisticated investors are realizing that they cannot achieve true diversification merely by being long a variety of asset classes.”
Samuels believes the majority of long-only returns are influenced by the direction of the overall markets and that long-short strategies are one of the few ways to achieve true portfolio diversification and risk control.
“Long-short represents the only asset class that can effectively handle both sideways and bear markets,” Samuels said. “The asset class allows investors an opportunity to systematically approach the markets and individual risk parameters differently than being long-only.”
Brian Lipton, founder of Gaithersburg, Maryland-based YellowWood Financial Advisors, seeks out investments that are not correlated with traditional stocks and bonds. He views long-short products as another piece to the portfolio-construction puzzle, and he has incorporated hedged equity mutual funds as part of a tactical allocation and as a way to reduce exposure to long-only securities.
“We realized long ago that we cannot time the markets,” Lipton said. “We typically allocate about 20% to 30% of our equity portfolios in a tactical manner. Hedged equity is a part of that allocation that helps satisfy certain risk elements, and, of course, allocations that reduce long-only exposure in this environment have been beneficial.”
Lipton has found that hedged mutual funds have been a very good choice during periods of intense volatility and could also work well during other times. Lipton’s firm, he said, uses one fund that goes long on favored positions, one that is short on out-of-favor, and another fund that buys equities and hedges them with short positions on various indexes. “While the latter fund is 100% hedged today, that percentage could change based on their views of the market environment,” he said. “Security selection is still important.”Display article as PDF for printing.
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