Alternative Investment Management Association Representing the global hedge fund industry
Despite delivering largely disappointing aggregate returns for a decade or more, stocks continue to play a hugely significant role in the performance of many investment portfolios. Small private investors and large institutions alike allocate to equities simply because they have investment objectives which cannot be met, or liabilities that cannot be funded through the rates of return currently available from other traditional asset classes.
The traditional arguments in favour of equities are compelling; over any given cycle, share prices should track corporate profits, which are themselves based on margins that are adjusted in accordance with rising input costs. Thus a dividend stream should rise in line with inflation and, as a share price represents the discounted value of these income streams, it too should rise accordingly. Conversely, unless they are index-linked, bonds provide no protection against inflation, but the advantage that they confer over cash is that the nominal income stream is guaranteed. This basic interpretation provides us with a logical hierarchy for the three traditional asset classes.
There is also plenty of analytical and academic support for the investment case for equities. Academics at the London Business School were behind the production of ‘The Millennium Book – a century of investment returns’. At publication, it was claimed that the Millennium Book was more comprehensive, accurate and authoritative than any earlier research, and it is not difficult to see why; it provides data for major asset classes and inflation in no fewer than 12 countries, which accounted for 90% of world stock market value at the turn of the century.
There is some dispute over the strength of equity returns during the first half of the 20th century but this piece of influential research highlights that investors have traditionally been well rewarded for carrying the higher risks associated with equities. As tabulated above, even Italy, the weakest of the equity markets covered by the Millennium Book, produced average real returns of 2.7% per annum over the 100-year period.
Distinguishing rhetoric from fact
Conventional wisdom suggests that the risks associated with equity investment are quite low compared with other asset classes. Indeed, investors appear to have tremendous faith in the buoyancy of major stock indices. Some of this belief stems from history, but a large part of it is based on spoon-fed rhetoric rather than actual statistics.
For example, in the midst of any bear market, we are repeatedly informed that equities are now much more attractively valued than they had been prior to the downturn. Moreover, when markets recover, we are sagely advised that it is only those who panicked and sold into the downturn, turning ‘paper losses’ into hard financial fact, which suffered. The patience of long-term investors has been, and will continue to be, rewarded. Sound familiar?
This accepted wisdom is based on the notion that equities have typically delivered satisfactory long-term investment returns despite succumbing to numerous falls of quite considerable magnitude. For example, US shares fell 23% in one day in October 1987, while UK investors suffered real stock market losses of 71% in 1973-74 during the period of hyperinflation. One of the starkest examples relates to the fall-out from conflict, with German equities declining by 91% in real terms during the post war (1945-48) period – yet the country’s stock market recovered to produce real returns of 4.4% per annum over the course of the 20 century as a whole.
Nevertheless, the Millennium Book researchers not only discovered countless cases of major market downturns, they also found (for example) that the standard deviation of real equity returns in the UK over the course of the century was 20% per annum. In other words, equity returns either out or underperformed expectations by 20% (or more) one year in every six, meaning that this is a very inconsistent asset class in which to invest heavily from a long-only perspective.
The non-normality of equity returns
The frequency of major stock market shocks is indicative of the non-normality of equity returns. With a normal distribution, the possible outcomes are symmetrically distributed, meaning that the mean return (which the investor receives) and the median (the middle value in the range) are close to equal. However, a negative skew in the distribution means that a disproportionate number of outcomes are distributed on the negative side of the mean and form a ‘fat tail’ (i.e. negative outliers, resulting from uncharacteristically sharp adverse movements, skew the return to the extent that the mean return is less than the median).
With the benefit of hindsight, we know that the 80s and 90s were particularly lucrative decades for stock market-linked investment. However, the most remarkable aspect of this period is not the performance of equities but the way that inflation was contained. This incredibly benign backdrop makes it a hugely unreliable period to use for establishing a precedent for future investment returns. Consequently, relying on a future resumption of such exuberant trading conditions, to offset the lean years seen since, is simply not practical. Investors need to be aware of the implications of negatively-skewed returns and seek to address this issue in constructing their portfolios.
Albert Einstein observed that ‘the most powerful force in the world is compound interest’ – large profits can be derived from the effect of continuously multiplying incremental gains over time. It could be asserted, with clear foundation, that Einstein was not necessarily advocating the most conservative approach to investment, but warning of the severe consequences of suffering a sharp reversal in the pursuit of greater gains. This is a concept that the Wall Street Journal refers to as the ‘cruel math of big losses’. For example, a fall in value of 40% in one year is not balanced out by a rise of equivalent proportions the next year. In fact, it would take a rebound of 80% to restore parity.
A long/short approach to equity investment
The first equity long/short (or ‘equity hedge’) fund was developed in the US in 1949 by doctor of sociology, Alfred Winslow Jones. His pioneering insight came from his appreciation of the complementary nature of leverage (investing borrowed money) and short selling (borrowing stock to trade). Both of these concepts were used widely in isolation, often for speculative purposes. However, Jones discovered that they could be effectively combined to produce a conservative investment portfolio.
Jones stepped down from fund management in the early 1980s. His track record demonstrated that he lost money in only three years out of 34, while the S&P 500 index recorded nine years of negative returns during the same period. Significantly, Jones’ fund substantially outperformed the market during the boom years of the early 1960s and also provided resilience during the sharp downturn of 1973-74.
As well as being one of the oldest and most popular hedge fund strategies, equity long/short is also a liquid and transparent discipline which is both intuitive and logical. The role of the strategy as a sustainable source of absolute returns is based on the additional flexibility that fund managers enjoy in trade expression, relative to their peers in the traditional long-only arena.
Numerous academic studies have shown that manager skill accounts for 10% or less of the return of traditional investment funds. Consequently, the performance of even the most skilful managers in the ‘long-only’ arena can be dominated by the direction of stock markets, which cannot be controlled. The reality is, therefore, that most people investing in traditional equity funds are either a beneficiary or a victim of the markets, depending on timing.
By way of contrast, long/short managers are focused on constructing portfolios based on high-conviction security selection and total, rather than benchmark-relative, risk. As the primary return driver is manager skill rather than stock market direction, the event risk associated with long-only investment can be constrained. In a portfolio context, it is possible for a long/short equity manager to aim to substantially participate in the upside of equity markets, earn positive returns in sideways markets and provide downside insulation during bear markets.
The rationale behind a long/short or ‘equity-hedged’ strategy is to achieve more consistent investment returns with a low correlation to that of the stock market. That is to say performance that is comparable to that of traditional equity disciplines, but with less downside risk.
The value of short selling
In 2008, the practice of short selling attracted much adverse comment as politicians and other public figureheads sought to apportion the blame for sharp falls in share prices across the financial sector globally. As the credit crisis heightened, in spite of a blanket ban in the short selling of financial stocks, it became widely recognised that ‘shorting’ was a natural reaction to toxic balance sheets rather than a fundamental cause of the market stress.
In his Nobel Laureate address in 1990, William F. Sharpe, one of the originators of the Capital Asset Pricing Model, referred to the ‘societal’ advantages of shorting. He stated that its exclusion would result in “a diminution in the efficiency with which risk can be allocated in an economy” potentially leading to lower overall welfare.
The problems associated with a one-sided market are effectively exacerbated by the use of leverage. Shorting is the obvious counterbalance to leverage both in terms of managing risk in a portfolio context and in creating market equilibrium. In addition, shorting increases the depth of the market, thereby reducing the spread, or transaction cost, incurred by market participants. Academic research demonstrates that market quality (i.e. greater liquidity with less volatility) is enhanced by short selling activity.
Indeed, in commenting on the impact of short selling restrictions in December 2008, Professor Charles Jones, Chair of the Finance and Economics Division at Columbia University, stated “virtually every piece of empirical evidence in every article ever published in finance concludes that without short sellers, prices are wrong”.
The ability to sell short therefore also promotes efficient price discovery because it allows markets to incorporate grounds for pessimism in share prices. This results in more accurate pricing of securities and helps to prevent misallocation of capital in the economy.
Alpha, stock dispersion and volatility
Advocates of the efficient market hypothesis (EMH), which first came to prominence in the 1960s, suggest that the benefits of obtaining and acting on superior information are overshadowed by the costs involved. In other words, they believe that the excess returns derived from successful stock picking will be exceeded by the expenditure associated with research and execution.
The underlying philosophy of EMH is that all traditional fund managers and equity analysts constantly seek securities with the potential to outperform the market. Consequently, the competition is so intense that any new insight about a company’s prospects is far from exclusive. Moreover, share prices will respond so rapidly that it virtually neutralises any apparent information advantage. This concept of a large number of investment professionals operating in the same field of research, and effectively cancelling each other out, is known as ‘overcrowding’.
Although certain trades can indeed become overcrowded, the EMH fails to take into account changes in market conditions. For example, the ability of active stock pickers to generate alpha is directly linked to dispersion (or the cross-sectional standard deviation of stock returns), which inevitably rises during periods of high volatility. Academic research conducted by Gorman, Sapra and Weigand1, demonstrates that the dispersion of returns has historically had a strong positive correlation with time series volatility and the movements of the VIX.
The problem for managers of traditional long-only strategies, which typically have low tracking errors and insubstantial active money, is that they require a higher level of volatility and dispersion in order to outperform than managers who are less benchmark constrained. Furthermore, as volatility typically increases in falling equity markets, traditional managers are seriously restricted by their inability to generate alpha from short positions.
Conversely, above-average volatility is favourable for managers of long/short disciplines because it creates bigger valuation anomalies, which can be exploited through negative as well as positive conviction. It follows intuitively that the potential alpha achievable from going long top-performing stocks and shorting the weakest performers increases exponentially as dispersion rises.
Although we can experience periods of uncharacteristically low volatility and dispersion – for example, the 2004-06 period – there is little doubt that valuation anomalies will continue to arise with unerring frequency. The most obvious reason is that the ‘hard’ and ‘soft’ forces which conspire to create them are enduring and endemic.
Hard factors relate to the ‘natural’ dispersion arising from micro inputs to stock performance, such as corporate structure, quality of management, business mix, input costs, geographic exposure and balance-sheet strength. Soft factors are concerned with investor behaviour, including cyclical preferences for growth and value stocks, ‘herding’ and emotional trading borne of fear and greed.
Gorman, Sapra and Wiegand analysed US stock market returns over a 17-year period and concluded that the extractable alpha from overweighting stocks in the top quartile and selling short the bottom quartile performers is large and ‘economically significant’. Consequently, there is no question of there being an inadequate supply of viable alpha (as the EMH purports). It is, in fact, a relative shortage of genuinely skilled managers which lies at the heart of the active versus passive debate.
Long/short investing in Europe
Europe constitutes a singularly fertile ground for active management and alternative trading strategies. On the one hand, the region offers an extremely diverse equity universe, with companies exposed to numerous and varied forces. From an opposite perspective, the progress that we have seen with market integration in recent years is also positive, but for completely different reasons.
Integrated stock markets decrease the cost of capital and thus foster productive investment. Similarly, a degree of integration provides enhanced opportunities for cross-border ‘pair’ trading, which is a major advantage in respect of the long/short and market neutral investment approaches. Consequently, it can be claimed that Europe offers a perfect mix of heterogeneity and homogeneity.
In the current environment, an asymmetric return profile is particularly pertinent and the rationale for investing long/short in Europe is therefore much more compelling than the long-only case. It is a huge call to try and infer whether governments are going to pull together in sufficient time to address the sovereign debt issues. However, this uncertainty means that investors are reluctant to allocate significant capital to Europe, which will create huge opportunities.
Valuations across many of the largest sectors are driven by a legitimate top-down view that European consumption is very weak. However, this is essentially based on the false premise that European companies sell exclusively to regional consumers. Rather than avoiding certain industries altogether, the most productive approach involves differentiating between the businesses that will prosper and those that are likely to struggle.
Dispersion in stock prices should therefore increase significantly in the months ahead, as analysts revise forecasts to reflect varying geographic exposures by target market. With interest rates seemingly set to rise sooner rather than later, the amount of leverage employed by individual corporations will also be closely scrutinised.
Nevertheless, as we saw in 2010, fears over the uncertainty of the macro backdrop can dominate the investment agenda from time to time. Consequently, the top performing funds are likely to be those with the ability to dynamically shift their emphasis between fundamental stock picking and top-down positioning, as market conditions dictate.
The dual objective of investment
By way of conclusion, most investors recognise the relationship between risk and return. However, many continue to focus on the more obvious component of the equation, leaving their portfolios vulnerable to adverse market movements. The principle of compounding can be cruelly blighted by one year of negative returns, but consecutive yearly falls, such as those seen in the 2000-02 period, create negative compounding which can have truly horrendous implications.
The dual objective of investment should therefore be to generate capital growth and provide downside protection, which is the goal of the long/short approach. Consequently, it is clearly no coincidence that the assets under management of equity long/short strategies increased by more than 200% in the 5-year period following the 2000-02 bear market2.
The existence of an abundance of sustainable and extractable alpha has been verified by academic research. Moreover, Europe is a region that lends itself particularly well to harnessing alpha opportunities from long/short investing, by virtue of the rich diversity of its equity markets, the range of varied forces that its corporations are exposed to and the ability to implement cross-border trading strategies.
The challenge for investors is to find a manager capable of crystallising the opportunities provided by stock dispersion into a meaningful and persistent source of returns.
 ‘The Cross-Sectional Dispersion of Stock Returns, Alpha and the Information Ratio’ Gorman, Sapra and Weigand (January 2010).
 HFR Quarterly report December 2006. The increase in assets refers to that of the strategies that fall into HFR’s ‘Equity Hedge’ style classification.
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