Tuesday, July 28, 2009 2 comments

Are long-short strategies and market neutral strategies the way to go?

If someone is looking for an answer, let me say straight up that I don't have a testable answer. There isn't much public data available on long-short or market-neutral strategies; someone in the shadow world (i.e. hedge funds) would know a lot more and have more concrete data.

In a post I made earlier in the year suggesting that value investing may underperform if we end up in a scenario like the Great Depression but it may do ok if we end up like Japan—to confuse everyone, I'm not even sure how true that is and I wonder about Montier's suggestions—reader R. Soul suggests that long-short equity funds should do well in an environment like the Great Depression. I would throw in market-neutral strategies into the discussion as well. How good are those strategies?

Benjamin Graham ran something close to a long-short fund with a long bias in the late 1920's/early 1930's. He got wiped out during the Great Depression because he was net long and used leverage. Graham supposedly had $2.5 million long with $2.5m short, but he also had $4.5m unhedged with $2m debt. Even though Graham probably wouldn't be considered as running a pure long-short fund, he, nevertheless, provides an example of how it may not work if you make mistakes (in the case of Graham, he was too long and indebted.)

There may be some academic work on the performance of long-short and market-neutral funds during the Great Depression but I am not aware of any. So, let's take a short cut and see how such strategies have fared during the current crash.

Modern Long-Short & Market-Neutral Performance

I don't know much about hedge funds and the best indexes to analyze. Perhaps the Credit Suisse Tremont hedge fund indexes are the most widely accepted—I seem them referred in news stories—but it is not freely available (you either need to register or pay for it.) Instead, let's look at two freely available indexes: Eurekahedge Hedge Fund Indices and Dow Jones Hedge Fund Indexes.

Reader R. Soul mentioned long-short but I think market-neutral is also somewhat similar and worth considering. There are different definitions of what these strategies entail but here is what Dow Jones says of the two strategies (I am quoting from the latest fact sheet: here and here):

Dow Jones Hedge Fund Indexes

Equity Long/Short
Seeks to add value by generating returns from undervalued long positions and overvalued short positions. Besides using individual short positions to enhance returns, shorting exchange-traded futures and options is also used as a means for hedging market risk. The Equity Long/Short Benchmark has a positive long exposure to the equity market, which can produce potentially greater return and consequently more risk.

Equity Market Neutral
Seeks to add value by capitalizing on differences in the “fair” and current relative valuations among stocks. The strategy buys stocks that are currently undervalued and sells stocks that currently overvalued, while maintaining a zero net exposure to the broad market, i.e., portfolio beta is zero, and consequently portfolio performance is uncorrelated to moves in the broad equity market. But moves towards “fair” values of the stocks held in the portfolio may generate returns.

Basically the long-short strategy buys undervalued stocks and sells short overvalued stocks, and has a slightly net long tilt. The market-neutral strategy buys undervalued stocks and sells overvalued stocks but maintains neutral exposure. You may have your own definition of what these strategies entail and other index providers may define them differently but the concept won't change.

The following graphic shows the performance of these two styles using Dow Jones Indexes in the last few years. I highlighted the last three years, as well as the YTD figures for this year.

There are a couple of things to note.

Both strategies performed well in the last couple of years (bottom table). Last year, the long-short posted -18.41% while market neutral posted -8.33%. This compares favourably to -37% for S&P 500 and -42.5% for Dow Jones Global. If we look at EurekaHedge's long/short index (pick long/short from the chart), it posted -20.30% (it doesn't have a market-neutral index.)

However, both strategies underperform in prior years (although long/short did ok in 2007). Even if you were bearish in 2007, you would have underperformed the broad markets.

It gets interesting if we start looking at the current year. Long-short is posting a gain of +1.92% so far, while market-neutral has returned -3.34% YTD. Both of these are worse than the broad markets so far.

So, based on these limited data points, it seems that if we get a few more years like 2008—this would resemble the early Great Depression period—then these two strategies will outperform. But if we get a typical bear market, with rallies in-between collapses (like 2009, so far), these strategies may underperform.

Not Sold On Them

I think it is reasonable to expect these strategies to outperform if we get precipitous declines, such as the 1929 to 1932 period. So R. Soul is right. But the real question is how they will perform if we get a long bear market like Japan? This is important to me because I think we are unlikely to see anything like the Great Depression; indeed, I am expecting something more like Japan (but it won't be as bad because stocks weren't as overvalued.)

The answer, it appears, is that these strategies don't look so good if we get a Japan-style decline—protracted; rallies and sell-offs; slow. In fact, if we mark the top as being 2000, we are already experiencing something like Japan. We have had huge rallies and collapses and it has taken many years—9 years so far. The collapse isn't as bad as Japan but that's partly because the Japanese market was way more overvalued.

So, my view is that, unless you were really good with these stratgies and consider it as your core investing strategy*, I don't think these strategies will help unless we get a replay of 1929-1932. If there is ever a rally, these strategies will underperform, just like how short-sellers, who were geniuses last year, are getting decimated this year. It's probably very difficult to time things properly so that you are long-short when the market is collapsing but long-only when the market is rallying.


* When I refer to long-short or market-neutral being your core strategy, I'm referring to people like John Hussman and David Einhorn. Although they don't fit the definition exactly, both of these guys use strategies that involve a lot of short selling and/or taking bearish bets using derivatives (eg. buying put options, selling call options, etc.) Although Hussman's main fund isn't truly a market-neutral fund, it is probably the best approximation for someone who doesn't run a hedge fund; Einhorn is generally very long but he resembles a long-short fund (Einhorn may also be classified as an activist investor to some degree.) These guys use these strategies all the time, even during bull markets, and aren't necessarily driven by the market. In contrast, if you or me only use these strategies only during severe bear markets, it's a totally different matter. We are timing the strategies and may not have built up much skill.


2 Response to Are long-short strategies and market neutral strategies the way to go?

July 29, 2009 at 11:36 AM

Here's the CS/Tremont info.  I didn't need to register.


Full paper from one of the articles on the right side of the page from the above link (opens as .pdf):  2H-09 paper

Sivaram Velauthapillai
July 30, 2009 at 11:08 AM

Thanks... didn't know how I missed that >:o  Their numbers seem simjilar the ones I referenced... the real test will be to see if these strategies, and the relevant funds, do ok once the market stabilizes...

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