The power of long-short in a pandemic market
Long-short strategies, which involve giving a fund manager the flexibility to profit when share prices rise or fall, were gaining traction before the pandemic. The trend has continued to accelerate since, but they remain an under-represented part of most investor portfolios. Whether due to a lack of understanding or perceived higher risk, heightened equity market valuations are once again forcing advisers and investors to think outside the traditional long-only 60/40 model in the hopes of protecting and growing their capital in this uncertain environment.
But not all long-short strategies are created equal. There are three main types of long-short strategy, each with its own unique objectives and characteristics: namely, market-neutral, leveraged, and traditional long-short. Market-neutral strategies, which require the long positions to equal the short positions, are the least common, seeking to deliver very low correlation (or ‘beta’) with the market, but generally delivering lower returns as a result.
Leveraged long-short strategies are the most aggressive, with 130/30 a common structure, allowing skilled managers to target outperformance by betting on which stocks will rise and fall in any given period. The most popular approach is the long-short or absolute-return strategy, which ultimately seeks to do both: protect capital in market sell-offs and maximise gains when markets rally. These strategies are generally long-biased, with some opportunistic short positions and the flexibility allowing the manager to reduce market exposure when volatility spikes.
Long-short strategies aren’t for everyone. By having a lower market exposure, they often don’t participate in large rallies – but on the flipside, they also aim not to participate in big market sell-offs. According to Coaster Capital, a long-short Australian equity specialist based in Sydney, the differentiator with what a long-short strategy can provide is the extra risk management tools that allow it to truly target absolute positive returns for clients, over the long term and through market cycles. While Coaster seeks to deliver positive compounding returns, long-short strategies have a strong focus on risk management, including position-sizing and correlation across positions. Strict leverage and liquidity limits are also important, on both the long and short side.
Long-short strategies also differ in the sector and regions in which they invest. Some are regional-focused, but range across all sectors – while other strategies invest in a single sector across the globe. Common sector-based strategies include healthcare, technology, and financial long-short funds. These sector-thematic funds allow the managers to use their specialist skills to take advantages of many opportunities across the globe.
One of the biggest benefits of long-short investing is the ability to effectively double (or triple) your investment universe. For example, imagine you are an Australian equity investor able to choose only from the S&P/ASX 100 index, but due to valuation concerns or poor fundamentals, only 20 companies are considered ‘investable’. If you then add the ability to short those companies that you have identified as being structurally or cyclically challenged during your research, then your realm of investment options increases substantially.
Nowhere is this fact more apparent than in the global listed infrastructure (GLI) securities sector, which is the focus of Coaster’s latest long-short strategy. Infrastructure, it says, is now ripe for a long-short strategy of its own. An active approach to the sector via a long-short strategy has appeal due to the wide dispersion in the sector, such as the varied outlook on airport patronage, toll-road traffic and impact of decarbonisation efforts across the globe. The strategy can target both the winners and losers of these huge structural shifts in the landscape – as opposed to just buying the winners in a long-only strategy.
One of the defining features of infrastructure is the highly regulated nature of the income streams. While a clear positive for yield-starved investors, this is one of the main opportunities of a long-short strategy. Regulation and legislation on similar assets vary across state and country borders, offering experienced investors a “regulatory arbitrage.” The level of regulation impacts everything from the regular payment of distributions to the valuation of assets, meaning that near-identical assets in different countries can trade at vastly different multiples, offering opportunities for specialist investors.
So far, listed infrastructure has remained one of the last bastions of long-only investing, with no specialist long-short strategies available in Australia and very few at all in the world.
In an environment where returns are getting harder to come by, it’s getting more important to find an edge that offers a competitive advantage of any kind. Long-short strategies may just be that edge.