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Preventive Medicine for Portfolios

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In November 2017, global equity markets posted their 13th-straight month of positive returns, as measured by the MSCI World Index. This was the longest winning streak in the index’s history, going back to its inception in January 1970.

Synchronized global growth, strong corporate profits, high operating margins, low interest rates, and low volatility have all been credited with aiding the market’s relentless ascent.

Given this environment, perhaps it’s not surprising that funds that can dampen portfolio volatility and truncate the downside when markets turn south haven’t exactly been flying off the shelf.

According to Morningstar, as of Oct. 31, 2017, assets under management for the entire Long/Short Equity category amounted to only $37.8 billion, a mere 0.4% of the assets under management in U.S. Equity and International Equity mutual funds and ETFs.

Further, over the trailing 12 months, long/short equity funds only took in $316 million on a net basis, while equity funds and ETFs brought in approximately $245 billion, or 775 times as much.

At a time when virtually all valuation measures for both public and private equities are at levels only partially exceeded during the tech bubble, and central banks around the globe are beginning to unwind their massive stimulus programs, it strikes us as more than a bit shortsighted that investors have been hesitant to embrace strategies with hedging properties.

But we get it, the S&P 500 returned 22.9% over the year ending in November, while the median long/short equity fund only returned about half that. What must happen though, for that kind of stock market performance to repeat?

Valuations are mean reverting. Profit margins are mean reverting. And economic growth and stock market performance aren’t highly correlated.

To believe that the market will simply continue to advance unabated is to believe that market conditions will get even better than what is already priced into asset values. Investing is always a forward-looking endeavor, and complacency and greed can be dangerous.

With that in mind, one of the primary advantages of long/short equity strategies is the ability to capture much of the upside when markets rise, while simultaneously dampening volatility and protecting against the possibility of a large loss.

The importance of which cannot be overstated.

As we’ve lived through two major market meltdowns since 2000, investors are painfully aware of the math of a big loss; it can take years to get back to even, losing the precious commodity of time along the way, which robs investors of the magic of compounding.

Consider that the maximum drawdown (i.e., the loss from peak to trough) for the HFRI Hedged Equity Index was 29.5% during the financial crisis while the S&P 500 experienced a drawdown of 50.9%.

An investor who experienced the loss equal to that of the HFRI index needed to generate a return of approximately 42% from the bottom to get back to even, while an investor in the S&P 500 required a return of 104%.

The point being, while a 29.5% loss is undoubtedly tough to stomach, climbing out of that hole is far less daunting than what faced long-only investors — and investors might not have time to rebound from significant losses, particularly those nearing retirement.

Investors need to be preparing for the next downturn now, precisely because predicting the timing of such an event is near impossible, and we know that our starting point in terms of valuations is ominous.

Investors need to be thinking about how to build portfolios in a materially different way from what they have done historically.

Traditional risk mitigators like investment grade debt will likely be unable to be nearly as effective as in the past, given current yields.

We believe that investors need to be reducing risk at this point in the cycle, both equity risk and interest rate risk, and one tool that can help to accomplish that goal is long/short equity.