Long/Short Equity and Equity Market Neutral – Describing Liquid Alts
Equity long/short strategies construct portfolios consisting of both long and short positions in equity securities and equity-linked derivatives but maintain an overall long bias with significant positive correlation to the overall equity market.
This type of fund might be utilized to provide some equity-market beta and allow the fund manager to try to add alpha by identifying overvalued and undervalued securities. Long/short funds with a target beta less than 1.0 also can be considered for use in a wider portfolio to assist in dampening portfolio volatility and providing some elements of diversification.
The long/short vehicle provides additional flexibility that allows active managers to generate positive (or negative) alpha by trying to identify undervalued securities for purchase and overvalued securities to sell short. Investment in this type of strategy requires a belief that active management can add value through stock selection, sector allocation, and market-timing.
After the 1997 repeal of the “short-short rule,” which allowed only 30 percent of fund income to be generated from short sales, this type of single-name focused equity long/short strategy became relatively easy to adapt to the ‘40 Act vehicle. We have seen many equity fund managers experienced with traditional actively managed mutual funds transition to this space.
We believe that selecting long/short managers is similar to selecting traditional long-only active managers. First, the selection process should determine if managers under consideration are indeed able to generate legitimate alpha. Given the particular risk management challenges associated with shorting securities, a manager’s risk management track record and acumen should be considered carefully. Second, managers have discretion in the amount of leverage employed by going long and short, and advisors should seek clarification on the amount of leverage employed.
Like the long/short category, equity market-neutral funds take long and short positions in equity market securities and derivatives. The difference lies in the absence of a systematic long-equity bias. The exact level of market exposure separating the two categories is somewhat subjective. The Morningstar fund classification system specifies equity index betas between –0.30 and +0.30 for consideration in this category. Fund returns are driven primarily by the fund manager’s ability to generate positive alpha in excess of fees. Fund strategies typically attempt to accomplish this through prescient stock selection, sector allocation, and market timing.
These types of strategies often are considered to be diversifying elements in a portfolio and a potential absolute return vehicle, ideally delivering pure alpha and low correlation to major asset classes. Because equity market-neutral strategies provide a larger role for short positions in the portfolio and focus on delivering absolute returns relative to long/short strategies, we believe manager vetting for risk management and alpha generation ability is even more important than for long/short manager selection.
This article was adapted from Ten Types of Liquid Alternative Mutual Funds: Why A Single Label Does Not Apply, as seen in the July/August Issue of IMCA’s Investments & Wealth Monitor.
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