The Role of Long/Short Equity Hedge Funds in Investment Portfolios

There is no one preeminent asset allocation scheme for delineating the role of long/short hedge funds in portfolios—it depends on an investor’s current positions and portfolio management structure. Approaches include allocating to an aggregate long/short category and populating the space with generalist managers that invest broadly. Alternatively, one can distinguish between geographic markets (developed, emerging, etc) or invest in styles (value/growth) as part of the overall equity allocation. In this article, I make the case for incorporating the alpha-generating capabilities and the implicit beta exposure of long/short managers explicitly in the asset allocation process. The first section reviews the evolution of long/short hedge funds. The performance characteristics of the long/short managers are then reviewed in the second section. The third section describes the basic determinants of long/short manager returns. This is followed by an analysis of what allocations to long/short managers might make sense. The final section discusses the attributes of various long/short managers who specialize in sectors. The key conclusion is that long/short managers have a demonstrated ability to outperform on a risk-adjusted basis compared to most long-only vehicles. I believe substantial allocations to these managers are appropriate regardless of whether one views them as a substitute for active equity managers or as a stand-alone hedge fund strategy. EXECUTIVE SUMMARY Long/short equity hedge funds have historically outperformed traditional long equity exposure with lower risk. This is a result of a demonstrated capability by long/short managers to generate alpha via stock selection, rotation in and out of cash and timely shifts in market exposures (e.g. large vs. small capitalization, sector, geography, etc). As a consequence, long/short managers have tended to generate a highly favorable characteristic: a higher correlation to equity markets in rising markets and lower correlation in falling markets (sometimes referred to as an “asymmetrical” risk/return profile). Over the past decade, assets under management by long/short equity hedge funds have grown more than 20% annually. This expansion was the most rapid of any hedge fund strategy and long/short managers have displaced global macro funds to claim the largest share of industry assets. Although a portion of this growth in long/short assets was attributable to market appreciation, the demonstrated ability of the managers themselves was also a key factor stimulating inflows. In my view, the optimum portfolio allocation should include adequate doses of “unconstrained” long/short managers in lieu of passive or active long equity exposure. Indeed, if one relies solely on the historical performance record, long/short managers would entirely displace traditional long-only managers. This view holds up even when long/short manager returns are liberally adjusted downward to reflect possible survivor bias. And while there is no guarantee that long/short manager performance will hold up in the future, it would take a severe deterioration in manager capabilities to justify no allocation, in my opinion. VIEWPOINT