by Cliff Stanton, CFA, 361 Capital

Long/Short Equity is by far the largest of the single strategy alternative mutual fund categories tracked by Morningstar. Why? Investment flexibility and the potential to dampen portfolio volatility are among the top reasons.

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In times of market uncertainty and dwindling returns from traditional asset classes, investors are looking to long/short equity strategies to capture equity-like returns while managing downside risk.

Investors find long/short strategies appealing for several reasons

1) Long/short managers can dampen volatility and help mitigate the possibility of a large loss. For example, the maximum drawdown 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 of the HFRI index needed to generate a return of approximately 42 percent to get back to even, while an investor in the S&P 500 required more than double—a return of 104 percent. Point being, while a 29.5% loss is undoubtedly tough to stomach, climbing out of that hole is far less daunting than what long-only investors faced.

Long/Short Equity Funds v. S&P 500 During Financial Crisis chart

2) The ability to go long or short provides the ultimate investment flexibility that is fully responsive to manager conviction. When long-only managers come across a security with a lower expected risk-adjusted return profile they can do one of two things: underweight it relative to the index or avoid it altogether. Long/short managers, on the other hand, have greater flexibility to express their views on all securities that they research. A security identified as having superior characteristics is purchased; a security with a poor outlook is shorted; and a security believed to have a market-like payoff is put aside until such time that either valuation or fundamentals turn it into a higher conviction long or short position. Greater efficiency is possible because more of the information uncovered during the research process can be acted upon.

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