Research

Long/Short Equity Strategies Struggle Led by Weaknesses in Europe

Long/short equity hedge fund strategies account for almost 36% of the global hedge fund asset under management (AUM), accounting for US$801.7 billion as of September 2016. Following a difficult start to the year, the strategy is on its way to recovery following four consecutive months of positive returns with the Eurekahedge Long Short Equity Hedge Fund Index up 2.47% for the year. However, given the challenging market environment since end 2013, long/short equity manager have posted low single digit returns over the last three years – up 3.69% in 2014, 3.04% in 2015 and 2.47% September 2016 YTD; a development that has slowed investor allocations into the strategy and contributed in part to a decline in the net growth activity (launches less closures). The outlook remains challenging for the moment, and the fourth quarter holds much in store from the outcome of the US elections to the Fed’s signalling on the pace of future rate hikes that could potentially limit the upside for the strategy.

Figure 1 below shows the performance of long/short equity managers since December 2007 against the backdrop of wider equity market performance as denoted by the MSCI World Index (Local). Long/short equity managers have outperformed the wider market, thanks in large part to their limited losses during the market downturn of 2008 which has over the years been the key part of their appeal to investors looking to improve the risk-return profile of their portfolios. The MSCI World Index was down 41.24% in 2008, with long/short equity managers outperforming them by almost 22% as they posted losses of 19.23%.

In terms of annualised performance over the almost eight year period depicted below, long/short equity hedge funds have posted gains of 4.43% which compares with 1.77% for the MSCI World Index (Local) and 0.37% and 3.11% for value and growth styles.

Figure 1: Long/short equity strategies since 2007

Long/short equity strategies since 2007

Table 1 shows detailed performance statistics over the past eight years. Key takeaways include:

  1. Long/short equity managers preserved capital in down markets – in 2008, 2011 and 2015, long/short equity managers outperformed underlying markets by 22.0%, 3.17% and 3.53%.
  2. During up markets, long/short equity managers lag the performance of the wider markets with the 2013 Bull Run being the most noticeable in terms of the performance lag where the MSCI World Index was up by 23.91% while long/short equity managers gained 16.04%.
  3. Long/short equity managers have posted the best risk-adjusted returns over the past five and three year periods, in large part due to their low annualised volatilities making them almost half as risky as traditional long only products by this one measure.

Table 1: Historical returns for volatility strategies

 

Eurekahedge Long Short Equity Hedge Fund Index

MSCI AC World Index (Local)

MSCI AC World Index IMI Value (Local)

MSCI AC World Index IMI Growth (Local)

2008
(19.23%)
(41.24%)
(40.42%)
(41.89%)
2009
25.89%
28.28%
24.94%
31.24%
2010
10.81%
10.11%
7.32%
12.67%
2011
(5.92%)
(9.09%)
(9.67%)
(8.39%)
2012
8.50%
13.55%
12.49%
14.61%
2013
16.04%
23.91%
22.46%
25.14%
2014
3.69%
6.79%
5.15%
8.46%
2015
3.04%
(0.49%)
(4.86%)
3.86%
2016 Sep
2.47%
3.38%
3.89%
2.82%
5 year annualised returns
6.99%
10.57%
8.86%
12.21%
5 year annualised volatility
5.47%
10.63%
10.65%
10.91%
5 year Sharpe Ratio (RFR=1%)
1.10
0.90
0.74
1.03
3 year annualised returns
4.77%
5.67%
3.64%
7.64%
3 year annualised volatility
5.07%
10.19%
10.07%
10.62%
3 year Sharpe Ratio (RFR=1%)
0.74
0.46
0.26
0.63
2 year annualised returns
2.95%
2.78%
0.10%
5.41%
2 year annualised volatility
5.48%
11.39%
11.24%
11.82%
2 year Sharpe Ratio (RFR=1%)
0.36
0.16
-0.08
0.37

Source: Eurekahedge


Figure 2 details the asset growth for long short equity strategies since their lows of 2008 when a combination of performance driven declines and ‘gating’ saw massive redemptions from the mandate. Subsequently, asset flows have recovered with the current AUM for the strategy at an all-time high, with 2013 recording the strongest influx of investor capital into the strategy, a record US$81.3 billion. Investor allocations (net flows) have trended lower since then, with only US$4.6 billion of net capital flows into the strategy for 2016, down from US$ 39.0 billion from 2015 as returns have soured in particular over the past three years.

The launch/closure activity for long/short equity managers can be seen in Figure 3. In recent years, launch activity has declined while closures have been inching upwards (barring 2016 September year-to-date). Overall, the net growth in the number of long/short equity managers has come down substantially over the last two years. A couple of reasons that explains these trends:

  1. The bulk of investor flows have chased the larger hedge fund offerings since 2008 given a preference for the big brands as well as their institutional quality governance structures that inspire confidence in their offerings. This has stagnated growth for the small to mid-sized players and has in effect raised the barriers to entry for smaller players with great ideas but little investor backing. For more details on the investor flow activity across hedge fund sizes please see this month’s Asset Flows Update.
  2. Average performance and management fees for new fund launches are in decline. This makes it difficult for smaller entrants already grappling with regulatory and compliance related costs to break even and hence puts the survival of otherwise good ideas at risk.
  3. The macro outlook for markets has been tough. Three years of low single digit returns by existing players in the industry coupled with investor frustration with existing offerings limits new entry only to the most compelling ideas that have good backing. With existing managers struggling to break past their former high water marks and their future performance based fee- gains uncertain, the mid-term business viability for small to mid-sized funds could be challenging. 

In Table 2 we see the regional return map for long/short equities mandated hedge funds. The strategy performed well across regional mandates after the financial crisis with Latin American and Asian long/short equities posting impressive returns, up 43.00% and 27.34% respectively in 2009 as investors flocked to the emerging world in the wake of the crisis. Indeed, the table is a guide in mapping events influencing capital movements in the markets since the strategy is somewhat closely tied to underlying equity markets.

One such example would be the Abenomics effect in 2013, which saw relatively stronger performance in Asian equity markets (Nikkei 225 Index +56.7% in 2013). While second to their North American counterparts, Asia long/short equities managers were up 18.30% in 2013 with the region leading performance among regional mandates in 2014 (+6.39%). Fast forward to 2016, Latin American long/short equities hedge fund managers gained 20.29% year-to-date thanks to the improved appetite in the assets of emerging markets. On the other hand, European long/short equities managers were down 2.03% year-to-date with weakness led by sector-specific causes such as Europe’s financial and banking woes contributing to much of the weakness with Brexit added further uncertainty. From the depths of sub-par performance, we are seeing stronger returns from North American hedge fund managers this year, gaining 5.43% year-to-date, compared to a decline of 0.32% in annual year 2015.

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