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The spectrum of long/short investing is broad – with some strategies being fully hedged to the market and others being fully exposed to the market. While each type of strategy can play a unique role in a client portfolio, investors should understand the typical exposures they provide and how they are likely to perform in various market environments. Unlike market neutral, which will almost certainly lag in up markets, and 130/30, which is likely to provide little downside risk mitigation during periods of market stress, long/short has the potential to perform well in both up and down markets and historically with a return profile in between that of market neutral and 130/30.How have long/short strategies performed?Figure 2 captures the returns of long/short relative to the broad market from January 1994 to June 2012. Over this more than 17-year period, long/short strategies have delivered stronger returns with lower volatility than the broad equity market. To be sure, long/short strategies have historically lagged the broad equity market during strong market rallies, such as in the bull market of the late ‘90s through early 2000s. A key component of this superior performance has been long/short’s ability to mitigate losses and preserve capital during the two large market drawdowns in 2002 and 2008. In falling market environments, long/short strategies are able to hedge risk and reduce equity market exposure in an effort to preserve capital. To be sure, long/short strategies have historically lagged the broad equity market during strong market rallies. This is an important point for investors considering a long/short equity strategy. By running a hedged portfolio with lower equity market exposure, long/short strategies can participate in market rallies, but are unlikely to capture all of the upside. But remember, long/short strategies seek to outperform by avoiding significant losses during market declines - not by capturing outsized gains. Long/short’s ability to participate in market upside while minimizing drawdowns has allowed for attractive long-term compounded returns over full market cycles, as Figure 3 demonstrates. As you can see in the capture ratios, long/short has preserved capital in down markets while participating in up markets. That is, it captured 54.4% of the gains in up markets while only capturing 42.1% of the losses in down markets. By reducing losses while capturing gains, long/short strategies have delivered similar returns with lower volatility than the broad equity market (see Figure 4).
Why consider a long/short equity strategy?For many investors, equity market exposure represents an important expected driver of long-term capital appreciation. However, as we have experienced over the last several years, equity markets do not always deliver positive returns and may be characterized by periods of heightened volatility. We believe equity market volatility is likely to persist as the world today faces significant macroeconomic risks: high debt levels in Europe, a fiscal cliff and political polarization in the U.S., and slowing global growth. In the current environment of unusual uncertainty in the global economy and financial markets, extreme events are not only possible but they are probable. In an effort to guard against extreme macro events, PIMCO believes investors would be well served to choose strategies that seek to dampen downside risk. Many investors have come to recognize that the constraints placed on traditional equity managers may limit their ability to manage risk and add value. At PIMCO, we see greater potential benefit from strategies that are flexible, unconstrained and incorporate downside-risk mitigation. All of our equity strategies incorporate downside risk mitigation whether it be through low-volatility or dividend-focused investing, tail-risk hedging, or in the case of our long/short strategy, the freedom to short stocks or raise cash. From alternative to mainstreamHistorically, long/short equity strategies were primarily only available in the form of hedge funds and limited partnerships. Today long/short equity strategies have migrated into more easily accessible, registered investment vehicles like 1940-Act mutual funds. These liquid alternatives offer daily liquidity and full transparency of portfolio holdings on a regular basis. Consequently, long/short equity strategies are becoming increasingly more popular as many investors are seeking strategies that provide exposure to the potential long-term benefits of owning stock, while also offering downside risk mitigation. We believe utilizing a long/short strategy as a complement to an existing long-only equity allocation can help an investor achieve these goals. Bon AppétitIt was not that long ago in this country that dining in all but the largest cities was defined by a steak house, often with a salad bar; a "Continental" restaurant; an Italian-American eatery; and Chinese takeout. As our food culture blossoms even diners in some of the most remote outposts are finding their options expand. After two stomach-churning bear markets, investors might also be ready to sample an alternative to the standard equity mutual fund fare. Something with the opportunity for a little downside risk mitigation could very well be the kind of good cooking investors are craving.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2014, PIMCO.
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