Long-short strategies are outperforming—or at least underperforming less—than traditional equity plays, according to a white paper by Credit Suisse.
The firm points out that year-to-date results for the MSCI World Index in May were down by 9.5%. Over the same period, the Dow Jones Credit Suisse Long/Short Equity Hedge Fund Index was down too, but by a comparatively slight 3.2%.
Part of the strength of the strategy is that while the long side of the equation has a high correlation with what the equity markets are doing (as much as 80% correlation with the MSCI World Index over the past two years), the short end of things offers downside protection (bet the wrong way, however, and the portfolio’s long assets will have to cover the loss). While the MSCI World Index lost 53.7% between November 2007 and February 2009, the Dow Jones Credit Suisse Long/Short index declined 22%.
For these reasons, Credit Suisse wants the strategy to be thought of more as a core strategy and less of an alternative.
Scott Weingarden, an advisor at Raymond James’s Starner Group in Coral Gables, Fla., says long/short hedging isn’t a core part of his strategy now and probably never will be, although the strategy has a place for wealthier clients with excess assets they can use for hedging strategies. Entry costs are getting more reasonable, he says, at $50,000 or $100,000 minimums for clients of a certain net worth. However, “you need a very skilled manager because shorting is an art that carries immense risks,” Weingarden says.
Most long/short managers’ strategy is simply to go long on their best ideas and short plays they find least attractive, a win-win on paper. However, the strategy mutes upside potential in a bull market. “Shorts weigh on returns,” Weingarden says, although he notes the strategy doesn’t promise the best return, but to smooth the ride. In general, though, the risk that managers will make the wrong bet on a short—too often it’s a timing issue, such as predicting exactly when the fixed-income bubble will burst, not that it inevitably will—it’s clear that “long/short is not common for a reason.”
To be sure, fitting a long-short strategy—or any hedging strategy for that matter—into a traditional investment portfolio is a challenge. First, does your client even qualify for the asset or net-worth minimums stipulated for alternatives investors? How does hedge fund allocations’ tax exposure impact your client’s portfolio? How liquid does your client need his or her assets to be? All of these questions, and more, come into play when talking about alternative options with clients, adds Shams Deitrick, a Raymond James advisor at Deitrick Wealth Management in Walnut Creek, Calif.
However, Deitrick says that if clients meet the myriad suitability requirements of investing, a 20% allocation diversified among hedge fund strategies is what he recommends. “In the last three years we’ve experienced a tremendous amount of volatility,” he says. “In the next 24 months you could make 30% or you could lose 30%, so why roll the dice? With alternatives you’ll make fair money going up and you don’t lose half going down. It used to be stocks and bonds. Why not stocks, bonds and alternatives?”