John Bennett, Head of European Equities, outlines why stretched equity valuations and low growth have driven investors towards equity long/short strategies. In this Q&A he explains his approach to managing long/short portfolios and why the benefits of being able to control market exposure and limit correlation to equity returns should prove useful in the foreseeable future.
Equity long/short funds have been gaining considerable interest and inflows over the past few years. Why is this?
I believe there’s little point in guessing the direction of markets, as markets exist to make fools of us (or at least those who forecast). In the past few years, however, investors have faced an unappealing combination of stretched equity valuations, volatility and income starvation. It is therefore not surprising that many have looked towards absolute return strategies, given their potential to provide steady returns in rising or falling markets. As long as stock correlations remain low this should remain a supportive environment for equity long/short funds with a focus on stock-picking.
On a day-to-day basis, how does managing a long/short fund differ from other strategies?
Don’t lose money. If you do, get out of the way, i.e. use the fund’s balance sheet to reduce exposure. You don’t have to be fully invested like a long-only fund, and we’re not interested in a ‘feast or famine’ approach. If we don’t think the market is (or will) pay us to play, we can reduce both the net and gross exposure, and we are very active in doing so.
I think too many long/short managers place a greater weighting on net rather than gross exposure, in the hope that short positions will offset long positions in difficult times. Hedge fund performance in 2008 and the last two years serves as a useful reminder of the perils of leverage – we are not afraid to remain impassive and reduce our gross exposure when necessary.
Over the past year, how has your performance been affected by global events and market pressures?
It hasn’t been an easy year, dominated by an increasingly schizophrenic market, political upheaval, and the global inflation/deflation battle. Furthermore, one of our key themes – healthcare – has seen poor sentiment thanks to US electioneering on drug prices and some disappointing operational results.
As conviction stock pickers you go through periods like this in markets and for us it is always about sticking to our fundamental analysis, learning from mistakes but holding conviction where the fundamentals continue to stack up. Thankfully despite this short-term stock picking drag we have limited losses through a lower gross exposure, and we still see multi-year positive prospects for a number of key themes, most notably healthcare and auto component suppliers.
What should a good long/short fund look like, in terms of portfolio structure?
Different approaches work for different people and there is no ideal balance. My approach has evolved through different market cycles since I first started running equity long/short strategies in 1998 and while I won’t always be right, I’m comfortable with the level of volatility and returns delivered to our investors. We balance a long-term thematic book (typically 65-75% of NAV) with more opportunistic holdings (25-35%). Both books are able to take long or short positions. Index futures and options can be used to protect the NAV in turbulent markets.
What is your outlook for markets?
We foresee a challenging outlook for growth globally and remain wary of extended valuations.
Every investor should be on the lookout for a change in the inflation vs deflation narrative: imagine the dislocation if inflation were to make a comeback.
Why should someone invest in an equity long/short strategy now?
Western equities have continued their valuation march upwards against a backdrop of yield starvation. While this may continue for some time longer, we can’t help feeling uncomfortable paying above 20x earnings for ‘steady growers’, ‘yielders’ and/or ‘low volatility’. An equity long/short fund is able to adapt to market conditions, chiefly through the ability to control its balance sheet, and therefore limit correlation to equity markets. In turn this should enhance the overall risk/return characteristics of a balanced portfolio. It has to be judged over a full market cycle.