Against the backdrop of the market uncertainty caused by the COVID-19 pandemic, investors have been reminded to seek ways to add resilience to their portfolios. It is an opportune time to consider the benefits that a long/short equity strategy could add to a diversified portfolio. This strategy makes up the largest component in the South African hedge fund industry and can offer a unique way to enhance the overall risk-return profile of an investment portfolio. The 36ONE equity long/short hedge funds can offer investors a more flexible approach to equity investing compared with traditional equity unit trusts (also referred to as long-only funds). Not only do they help portfolios retain exposure to equities – which provide the best returns over the long-term – but more importantly, they act as a shield by providing protection when the market declines.
Long/short equity strategy versus traditional unit trusts
The 36ONE long/short equity strategies have the same investment universe as our unit trust counterparts, with the main difference being that they have a broader toolkit at their disposal and are therefore able to use techniques that are not available to our traditional unit trust funds. As the name suggests, our long/short equity strategies invest both long and short in publicly traded equities and equity-related instruments. Similar to our traditional long-only equity funds, our hedge funds invest in companies that we believe will increase in value. This is referred to as going long. Hedge funds, however, have the added benefit of being able to make money in companies that decrease in value (often characterised as businesses with unsustainable returns, low cash flow generation and weak corporate governance). This is referred to as going short (or shorting).
Shorting involves borrowing and then selling a security, with the expectation that the price will decrease, allowing the seller to buy the security back at a lower price and return them to the owner. By selling high and buying low, hedge funds can profit on the differential between the two prices.
Increases diversification
The bi-directional investment strategy (ability to go both long and short) provides our investment team with a lot more flexibility by making use of all the information they uncover during the idea generation and research process. Investment analysts typically spend most of their time analysing and understanding businesses that they like and anticipate will increase in value. Hedge fund managers do the exact same, except through their efforts they also identify businesses that they don’t like (or like the least) - as there is opportunity to make money on both sides. A traditional long-only equity fund’s ability to capitalise on the latter information is limited. The primary form of defence available to them is to be underweight these securities relative to a designated benchmark. This doesn’t allow for the opportunity to profit from a decline in the price of these securities, nor does it allow for reduced volatility by adding uncorrelated positions to the fund. This is where hedge funds can be particularly useful. Shorting the security, as is done in the 36ONE equity long/short strategies, allows us to fully express our views and conviction. This is particularly useful in the context of South Africa where the equity market has inherently exhibited a high degree of concentration risk with few stocks representing more than 50% of the market. The ability to go long and short broadens the portfolio’s ability to benefit from a larger opportunity set. We are of the view that a long/short equity strategy should be considered as an alternative way to hedge against the current economic and political headwinds that face South Africa in addition to offshore investing. ASISA classified South African long/short equity strategies can invest according to the SARB limits of 30% to international investments and a further 10% in Africa excluding South Africa. As a result, these funds can provide further diversification by including international assets.
Offers additional sources of alpha
Moreover, the ability to short securities can provide the long/short equity hedge fund an additional source of alpha, resulting in positive returns being generated in both upward and downward trending markets. A further source of revenue that shorting introduces is upfront cash (through the sale of the borrowed security). This cash can either be deployed to buy more securities or simply used to earn interest, which is then reinvested in the fund (the interest earned on the cash is far larger than the small fee the manager pays to borrow the security).
Improves risk-return profile
Not only can these strategies generate profits from their long and short positions, but the short positions act to reduce market exposure (beta) and can provide an element of protection (or hedge) when markets decline. This is because the gains on short positions will offset the losses on long positions. The risk-mitigating benefits of long/short strategies are elevated further by the managers’ ability and flexibility to dynamically adjust their exposures in response to changing market conditions. Such strategies are typically focused on achieving absolute returns as opposed to relative returns. Managers have several mechanisms at their disposal to reduce risk and protect capital such as reducing overall portfolio gross exposure by concurrently selling longs and covering shorts, resulting in the portfolio having less capital at risk. They can also reduce position sizes to decrease volatility, as well as add portfolio protection in the form of derivatives. The result is that long/short equity hedge funds have, on average, returned equity-like returns with significantly lower levels of volatility, while providing smaller drawdowns during severe downturns. The ability to mitigate volatility and limit the size of losses is particularly important to investors who need to draw on their investments regularly, such as investors with living annuities.
Graph 1. The 36ONE SNN QI Hedge Fund vs the ALSI in positive months, negative months and the combined effect
Source: Bloomberg. Average 36ONE SNN QI Hedge Fund and JSE All Share Total Return Index performance since inception (April 2006) to September 2020.
Graph 1 above shows the average monthly return since inception (174 months in total) of the 36ONE SNN QI Hedge Fund relative to the FTSE/JSE All Share Index (ALSI). We have also compared the average returns during the months where the ALSI generated positive (105 up months) and negative returns (69 down months). During up months, the fund manages to capture two thirds of the ALSI, which is not surprising as the hedge fund is not fully invested in equities. However, and perhaps more importantly, during the down months the Fund has protected our clients’ capital to a much greater extent than the ALSI, resulting in the Fund outperforming the ALSI overall. Looking at more recent events, Graph 2 below illustrates the performance of the 36ONE SNN QI Hedge Fund compared to the ALSI and Capped SWIX indices during the Coronavirus-driven market correction at the start of this year. As is evidenced by the below chart, the 36ONE hedge fund was flat over the 3 month period compared to the Capped SWIX which was down close to 30% at one stage:
Graph 2. The 36ONE SNN QI Hedge Fund vs the ALSI and Capped SWIX during COVID extremes
Source: Bloomberg, monthly returns.
It’s important to note that the returns shown in graphs 1 and 2 above illustrate the returns on a monthly basis, however, when one considers the effects of compounding and the impact of this monthly outperformance over the 14 year track record of the hedge fund, the end result is astonishing. The fund has returned an average of 15.7% (after fees) per annum since inception in April 2006, but importantly it has achieved this outperformance with a fraction of the volatility as shown in the below table:
We believe that the equity climate, specifically in South Africa, requires a more agile approach to equity investing. Including an allocation to long/short equity strategies in a well-balanced portfolio can provide valuable downside risk-mitigating benefits while also providing the ability to reap rewards when markets recover. According to HedgeNews Africa, roughly half of the funds in the South African equity long/short category are classified as CIS retail hedge funds. This type of hedge fund looks and feels like a traditional long-only portfolio with low investment minimums, while providing daily pricing and liquidity. Hedge funds have become a lot more accessible to investors thanks to increased regulation which brings greater protection for investors in South African retail hedge funds.
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