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Long/Short Investing: Bon Appétit

After two stomach-churning bear markets, investors may be ready to sample an alternative to standard equity mutual fund fare.

When I’m not busy looking for the next great stock opportunity one of my pastimes is cooking, so much so that my cookbook collection has completely overtaken all our available shelf space. In response, my wife has issued a rule: No new cookbook enters the house without one leaving. I’ve kept implementation at bay so far, but if she insists, then my 1973 copy of "Seven Hundred Years of English Cooking" will be the first to go. I admit it hasn’t seen much action.

When it comes to picking a favorite cuisine, I admit I’m non-committal. As the late American food writer and gourmand James Beard said, “I don’t like ‘this’ cooking, or ‘that’ cooking, I just like good cooking.”

Beard’s omnivorous, no-rules approach – call it unconstrained – can be applied to all manner of activities, even investing, an enterprise with no shortage of dictums describing how it should and shouldn’t be done. Think “buy and hold,” don't carry too much cash, and stay away from shorting.

Unfortunately, after these rules were coded into gospel, the stock market in the late 1990s took off on what has been a 12-year volatility ride that has included two bear markets that cut U.S. stocks by half or more. During such a roller coaster ride, the ability to sell some stocks in the face of rising risks, raise some cash or put on a short or two might be a welcome alternative to all the mutual funds offering long-only, fully invested entrees. It’s not that long-only, buy-and-hold, fully-invested doesn’t have a place. It most certainly does. But it's not the only dish, and not the one you always want or need.

When people hear of investing alternatives such as “long/short” they often think of complex, exotic strategies that are even more risky than traditional investments – the investing equivalent of today's high-end molecular gastronomy. However, long/short investing can be driven by strategies that we believe offer a prudent approach to seeking equity-like returns with improved downside-risk and volatility mitigation over the long term.

Relaxing the long-only constraint
In many ways, long/short strategies are similar to long-only strategies. Managers of these active strategies seek to form an investment view on which stocks are likely to rise in value and which stocks are likely to decline.

Long-only managers implement these views by investing in stocks they believe will rise and avoiding stocks they believe will decline. Long/short managers will also own stocks they expect to appreciate. However, long/short is distinct in that these managers can take short positions in stocks they believe will fall. By removing the long-only constraint, long/short managers have an expanded opportunity set with the potential to generate returns from both long and short investment ideas. The more flexible mandate of long/short strategies provides additional tools in an effort to generate returns and manage risk. 

Nuances of long/short investing
There is a wide variety of investment strategies that incorporate both long and short positions. However, “long/short equity” specifies a distinct investment approach that seeks to reduce downside risk while still capturing much of the equity market’s upside potential. This is different from the market neutral and 130/30 strategies that are commonly associated with long/short investing.

Figure 1 provides a quick review of some of the key differences between these distinct investment strategies:

  • Market neutral: As their name implies, market neutral strategies seek to minimize their exposure to the market. This is often achieved by investing an equal amount of the fund’s assets in both long and short positions so that the net exposure of the fund is zero. For example, if 50% of the fund was invested in long securities and 50% was invested in short, the net exposure to the market would be 0%. A well run market neutral strategy has a beta (exposure relative to the benchmark) close to zero and relatively low volatility. Market neutral strategies aim to consistently deliver modest gains, slightly above the nominal risk-free-rate*, regardless of the market environment. 

  • Leveraged long/short (130/30): These strategies are most similar to long-only strategies in that they are fully exposed to the equity market (i.e. beta of 1.0**). Leveraged long/short strategies reinvest the proceeds of their short sales to obtain additional long exposure to the market. A common example of a leveraged long/short strategy is a 130/30 (or 120/20, 150/50, etc.) fund. These funds invest 130% of their assets in long positions and 30% in short positions, resulting in a net market exposure of 100%. Leveraged long/short strategies seek to generate returns above an equity benchmark and have volatility similar to the equity markets.

  • Long/short: Long/short equity strategies come in a variety of flavors and a wide range of market beta, but they all aim to have lower long-term volatility and risk profiles than the equity market as a whole. Success in this category is seen to be widely dependent on a manager’s ability not only to select stocks, but also to know when to have more or less exposure to the overall market. Long/short strategies invest up to 100% of their assets in long positions while taking varying short positions. Generally these strategies are long-biased, meaning their short positions do not fully offset their long positions.

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 mainstream
Historically, 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 Appétit
It 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.

Laura Schlockman contributed to this article.

Disclosures

*The "risk free" rate can be considered the return on an investment that, in theory, carries no risk. Therefore, it is implied that any additional risk should be rewarded with additional return. All investments contain risk and may lose value.

**Beta is a measure of price sensitivity to market movements. Market beta is 1.

Past performance is not a guarantee or a reliable indicator of future results.  Equities may decline in value due to both real and perceived general market, economic and industry conditions. Investments in value securities involve the risk the market’s value assessment may differ from the manager and the performance of the securities may decline. Investing in securities of smaller capitalization and mid-capitalization companies tend to be more volatile and less liquid than securities of larger companies. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets.  Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. High-yield, lower-rated, securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. REITs are subject to risk, such as poor performance by the manager, adverse changes to tax laws or failure to qualify for tax-free pass-through of income. Entering into short sales includes the potential for loss of more money than the actual cost of the investment, and the risk that the third party to the short sale may fail to honor its contract terms, causing a loss to the portfolio. Tail risk hedging may involve entering into financial derivatives that are expected to increase in value during the occurrence of tail events. Investing in a tail event instrument could lose all or a portion of its value even in a period of severe market stress. A tail event is unpredictable; therefore, investments in instruments tied to the occurrence of a tail event are speculative. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested.

Dow Jones Credit Suisse Long Short Equity Index is an asset-weighted hedge fund index derived from the TASS database of more than 5,000 funds. The directional strategy involves equity oriented investing on both the long and short sides of the market. The objective is not to be market neutral. Managers have the ability to shift from the value to growth, from small to medium to large capitalization stocks, and from a net long position to a net short position. Managers may use futures and options to hedge. The focus may be regional, such as long/short U.S. or European equity, or sector specific, such as long and short technology or healthcare stocks. Long/Short equity funds tend to build and hold portfolios that are more concentrated than those traditional stock funds. The S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The index focuses on the Large-Cap segment of the U.S. equities market. It is not possible to invest directly in an unmanaged index.

This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. ©2012, PIMCO.