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Digital Subscriptions > The Hedge Fund Journal > Issue 124 - July 2017 > Rethinking Equity L/S Allocations For Retail Investors

Rethinking Equity L/S Allocations For Retail Investors

How to solve poor performance, excessive fees and blow-up risk

The model for allocating to equity long/ short funds is broken. The mentality of most allocators is to chase the “hot dot” – that is, invest with a fund that performed well recently and hope the hot streak continues. This approach is based on the discredited assumption that allocators can easily identify which funds will perform well going forward. In addition, the risk inherent in individual equity long/short funds is widely misunderstood – the equivalent of conflating the risk of a single stock with a diversified index. The net result is a decade of disappointment among clients who expected.

The alternative (and, we argue, superior) approach is to reframe investing in equity long/short as a “category” allocation – akin to investing in a passive, diversified index at low cost rather than making concentrated bets on high fee, volatile individual constituents. In fact, the actual, live performance of a simple, factor-based replication portfolio we’ve managed since 2012 has outperformed 80-90% of individual funds on a risk-adjusted basis with low fees, daily liquidity and transparency – a package that, overall, should be far more compelling to any allocator seeking to include equity long/short strategies within a diversified portfolio.

The factor-based replication approach that we advocate is the culmination of ten years of research and provides a data-driven solution to the pitfalls experienced post-crisis by many investors in liquid alternatives products.

Why invest in equity long/short strategies?

Why invest in equity long/short in the first place? The simple reason is that an allocation to equity long/short can improve the risk-adjusted returns of a diversified portfolio. Since January 2000, ELS hedge funds outperformed global equities with far less risk (see Fig.1).

In a 60/40 portfolio, nearly 90% of portfolio risk comes from the equity allocation. The substitution of a 20% allocation to equity long/short from higher risk equities over this period of time would have improved the Sharpe ratio of a traditional portfolio by 24%.1 Granted, equity long/short strategies are expected to underperform during strong bull markets, but historically this has been offset by the protection of capital during bear markets. Today, in the ninth year of the second longest bull market in history, at an important inflection point in monetary policy, the case for equity long/short is stronger than it has been in years – provided the implementation avoids some of the pitfalls outlined below. From a client management perspective, a proactive allocation that preserves capital during the next crisis should prove to be highly valuable.

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Informing the Hedge Fund Community. With access to some of the industry’s biggest names and an astute and talented group of writers and contributors, The Hedge Fund Journal has established itself as a trusted source of information on the hedge fund industry.