Long/Short Funds Go 'Unhedged' in Energy



Equity markets snapped back from the prior week’s selloff to end the week in the black. The S&P 500 and Dow Jones Indices gained approximately 0.3% and 0.4%, respectively. Small cap stocks finished the week up roughly 1.5%.

The week was light in terms of economic data. Service sector data opened the week up on positive footing as the ISM Non-Manufacturing Index touched its highest level since its January 2008 inception. The index registered 58.7 in July with improvements across most leading subcomponents. This surpassed June’s reading of 56.0 and consensus estimates of 56.5. Business activity/production gained 4.9% while new orders, employment and imports were also higher. Inventories along with surveys for prices and inventory sentiment dipped slightly. 

On the manufacturing side, factory orders exceeded expectations, jumping 1.1% in June. The reversal from a negative May reading was due in large part to the durable goods component, which was revised up to 1.7%. The initial reading, which was released July 25, came in at 0.7%. Non-durable goods was also strong, jumping 0.6% after a 0.2% decline in May. 

U.S. trade data came in positive for June as the trade deficit narrowed to $41.5 billion from $44.7 billion in May. Exports inched up 0.1% while imports dipped 1.2%. Trade deficit improvement was led by the goods excluding petroleum gap, which declined from $47.1 billion in May to $44.8 billion for June. The petroleum balance also declined, from $15.2 billion in May to $14.7 billion in June. A narrowing trade deficit should prove positive for the second estimate to second quarter GDP growth. 

Consumer credit rose in June by $17.3 billion, coming in below consensus forecasts of $18.7 billion. This was driven by the non-revolving component, which rose $16.3 billion on vehicle refinancing and government acquisitions of student loans. The revolving component was up just $0.9 billion as consumers remain hesitant to take on new debt aside from vehicles. 


Rounding out the week was data on wholesale inventories, which rose 0.3% in June, coming in below consensus forecasts of a 0.7% rise. Wholesale sales of autos continue to be strong, jumping 2.1% in June. The report shows that inventory levels are roughly in line with sales, meaning wholesalers have not gone too far in restocking their goods.  


Over the course of 2014 investors have come to notice the increase in net exposures amongst long/short equity managers. Many investors have grown somewhat wary of this development. Given the market’s relatively uninterrupted run-up since late 2012, it is rational to think that these types of strategies might naturally lower their overall net exposure. 

So what is behind this elevated exposure? As the chart below indicates, long/short funds have been increasing exposure to one particular sector: energy. Net exposure within the energy sector has nearly tripled since the summer 2013. 

This provides a bit of rationale for long/short managers’ general underperformance in July as the HFRX Equity Hedge Index lost 1.6% against the S&P 500’s 1.4% decline. Negative alpha likely resulted in large part from an overweight to energy as the sector fell 3.3% in July, more than twice that of the S&P 500 and Russell 1000. 

During the second quarter, many long/short mutual funds were running with an overall exposure to the energy sector comparable to that of the Russell 1000 Index. While it would be nothing to tout for a long-only fund, this is noteworthy considering long/short funds’ overall allure as a hedged solution to equities investing. Diamond Hill’s L/S Fund ended the second quarter with a 10.7% net exposure to the energy sector while the Russell 1000 had a 9.9% weighting. Robeco and Neuberger Berman, while less than the broader equities index, had much more exposure to energy names than their roughly 50% overall net profiles would suggest. This indicates that they too had a substantial overweight to the sector. 

Even more noteworthy is the exposure to the sector from the less directional strategies. TFS and BlackRock, whose strategies by nature are more market neutral, have outsized exposures to the sector. BlackRock ended the quarter with a net exposure of roughly 5.0% and beta of less than 0.1. Yet, they had a net exposure of 9.0% to energy stocks representing a monumental overweight to the sector. 

While the opportunity set may be fertile for energy stocks given the long-term outlook for the sector, investors must be cautious when selecting a hedged strategy for inclusion in a total portfolio. An outsized allocation to any sector can be costly, as was the case in July.  


Economic data releases pick up again this week, led by the NFIB Small Business on Tuesday morning.  Other notable reports include advanced retail sales, import and producer price indices, and industrial production. The University of Michigan/Thomas Reuters Consumer Sentiment Index rounds out the week. 

Earnings releases are scheduled for Caesars Entertainment, Cisco Systems, Macy’s, and Wal-Mart amongst others. 

Notable central bank policy announcements are due from Korea, Indonesia, and Chile.  


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