Investment Strategy's Role in Portfolio Security: Fact or Fallacy?
In the world of hedge funds, one strategy that has garnered significant attention is the Equity Long Short (ELS) strategy, known for its 130/30 strategy. This strategy, however, may not be the panacea for portfolio protection that some believe it to be.
During the volatile period caused by the Covid-19 pandemic lockdowns, investing in a combination of the S&P 500 and bonds would have saved 20.59% of the S&P 500's drawdown, compared to an ELS portfolio. This is indicative of the high correlation between ELS and the S&P 500 during months with negative returns, unlike traditional hedges like bonds and gold.
The key drivers of ELS returns are stock selection skill, factor strategies, and market hedging. Managers aim to capture alpha from relative mispricings by going long on attractive stocks and short on unattractive ones. They also exploit factor premiums such as value, momentum, and quality, and have the flexibility to reduce net market exposure, thereby managing downside risk and volatility.
However, these returns are primarily driven by the market, and a large portion of ELS returns is not desirable for investors. The up capture is lower than the down capture, and the correlation on up months is lower than on down months. This means that ELS may not provide the expected protection during market rallies.
In terms of diversification and alpha, ELS strategies offer low correlation to traditional long-only equity markets and to each other, providing useful diversification within a portfolio. However, performance dispersion among managers is wide, reflecting differences in skill and strategy. The fee structure, often around 2% management plus 20% performance fees, can be high but may be justified if the strategy delivers strong risk-adjusted returns and diversification.
Despite these potential benefits, research shows that a simple, cheaper portfolio can provide better performance and risk reduction compared to a portfolio including ELS. For instance, a 30% S&P 500 - 70% cash portfolio can replicate ELS returns with a 98% correlation to the ELS Index.
The research can also be used to analyze individual funds instead of an average or index level return profile. Interestingly, the S&P 500 + Bond portfolio has reduced drawdowns over its peer, but surprisingly, it also outperformed the S&P 500 + ELS portfolio on an absolute return basis.
In conclusion, Equity Long Short strategies can provide sufficient diversification and alpha to justify their fees if investors select skilled managers with proven track records and strategies suited to current market conditions. However, the wide dispersion of outcomes means careful due diligence is essential before investing. The goal of an alternative investment product like ELS is to diversify a portfolio without sacrificing significant portfolio return expectations. However, the research suggests that simpler, cheaper strategies may offer better performance and risk reduction.
In the realm of finance, a business strategy such as Equity Long Short (ELS) may not offer the desired portfolio protection during market rallies, as demonstrated by its high correlation with the S&P 500 during negative return months. Contrastingly, investments in a combination of the S&P 500 and traditional hedges like bonds can provide better risk reduction, offering an alternative for investors seeking to manage their portfolio's return expectations.
