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Losers can still add value: The case for long/short investing

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By Jean-Christophe de Beaulieu
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5 minute read

Winners get so much attention but don’t forget the losers. They can add value too, says Acadian’s Jean-Christophe de Beaulieu.

The phrase “wooden spoon” commonly describes a person or team that has come last in a competition, in other words, the worst performer.

In the sporting arena, the West Coast Eagles claimed the 2023 AFL wooden spoon, the Wests Tigers got the NRL award, and the Wallabies were a strong contender for worst on field at the Rugby World Cup.

When it comes to investing, international fixed interest has been the worst-performing asset class so far this year and, in global equity markets, sectors like utilities have significantly underperformed.

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It is easy to brush off the losers. In all aspects of life, people like winners.

Asset management is no different. The focus is on picking winners, primarily because long-only equity strategies dominate the landscape.

However, against a backdrop of heightened economic and geopolitical uncertainty, the focus is shifting to long/short equity strategies given their potential ability to outperform in different market conditions.

While Australian and global shares have performed strongly for many years, delivering an average of circa 11 per cent and 10 per cent per annum, respectively, for the past 10 years, equities are starting to appear relatively expensive.

Furthermore, equity investors face significant headwinds.

Rising interest rates, inflation, and cost-of-living pressures are putting enormous pressure on households, businesses, and governments.

Consumer and corporate spending is slowing, as is global growth.

In this environment, shares have historically underperformed and, as such, investors are being told to temper their expectations.

Difficult market conditions present obvious challenges but they also present opportunities, particularly for those who can identify and capture mispriced assets on the long (undervalued) and short (overvalued) side.

This approach is often described as relaxing the long-only constraint.

With long-only equity strategies, investors can only buy stocks so they are looking for undervalued companies, as they believe their share price will go up.

When equities are expensive, their opportunity set is reduced.

The only thing long-only managers can do if they don’t like a stock is choose not to hold it in their portfolio.

Long/short equity strategies, on the other hand, can also take a negative position on some stocks, hence increasing the opportunity set and diversifying the sources of risk and return.

Since they can benefit from the price of stocks going down, managers may be able to deliver alpha (performance in excess of the market return) through both bullish and bearish markets.

An institutional staple

Long/short strategies are not new. They have been around for a long time but they really started to grow in popularity among institutional investors, like superannuation and pension funds, at the turn of the century.

Since then, they have been a staple in institutional portfolios.

Historically, retail interest has been less enthusiastic, due largely to a lack of awareness and the added complexity and risk attached to short selling.

The strong performance of long-only equities also meant investors didn’t need to look elsewhere or take on extra risk to get decent returns.

To short a stock, investors effectively borrow a stock and sell it at a certain price with the intention to buy it back at a lower price in the future.

Unlike long-only strategies, where losses are capped at the initial investment, if an investor shorts a company and the stock price rises, there is the potential to lose more than the initial investment, as there is no upper limit on the share’s price.

Furthermore, if a short position increases in value, that investment becomes a bigger part of a portfolio, partly explaining why most long/short strategies follow a 130/30 construct that limits their short exposure.

With a 130/30 strategy, managers invest 130 per cent on the long side and can short 30 per cent of the portfolio, deploying 160 per cent gross exposure.

A risk-controlled, highly diversified 130/30 strategy can still maintain a beta of one, meaning it has similar market risk as the index.

This is because the strategy is self-leveraging and the 30 per cent short book hedges out the additional market risk and volatility of the 130 per cent long book.

As a result, over the long term, a well-constructed long/short portfolio has the potential to outperform a long-only strategy with the same amount of capital allocated.

Suitable for different markets

While long/short equity strategies can appear more complex than long-only strategies, they have the tools and flexibility to outperform in different markets, without incurring materially more total risk.

For the past decade, companies have benefited from cheap and easy money, higher profit margins, and strong asset values. This has increased the risk appetite and profile of companies, with many amassing debt to invest in projects and accelerate growth.

In an environment of higher interest rates and heightened economic and political instability, this pace of growth is unsustainable.

For professional investors seeking exposure to equity markets but looking for some downside protection, long/short equity strategies may be an option in a diversified portfolio.

Jean-Christophe de Beaulieu, head of investments, Acadian Asset Management Australia

Losers can still add value: The case for long/short investing

Winners get so much attention but don’t forget the losers. They can add value too, says Acadian’s Jean-Christophe de Beaulieu.

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