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DRS vs. Long/Short Strategies

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Strategy Comparison Series

One of the old­est forms of “alter­na­tive” invest­ing involves short­ing stocks. Alfred Winslow Jones is wide­ly cred­it­ed with cre­at­ing the first hedge fund back in 1949. Jones’ pri­ma­ry strat­e­gy involved not only invest­ing in stocks he liked but also short­ing those he dis­liked. Long/short invest­ing remains a pop­u­lar hedge fund strat­e­gy, and these days, it is avail­able in 1940 Act mutu­al fund for­mat as well. Accord­ing to Morn­ingstar, there are 119 long/short mutu­al funds with an aggre­gate $26.5bn in assets as of Sep­tem­ber 30, 2017.

As part of our ongo­ing series ana­lyz­ing dif­fer­ent alter­na­tive strate­gies, we seek to answer the fol­low­ing ques­tions regard­ing long/short funds:

  1. What are the dri­vers of returns in each strat­e­gy?
  2. What are the risks in each strat­e­gy?
  3. What role does a giv­en strat­e­gy play with­in a port­fo­lio?
  4. How does the giv­en strat­e­gy com­pare to the Defined Risk Strat­e­gy?

Drivers of Returns

In most cir­cum­stances, the dri­vers of returns in a long/short strat­e­gy will be at the indi­vid­ual stock lev­el. The whole val­ue propo­si­tion of long/short strate­gies is that a port­fo­lio man­ag­er should be uncon­strained and prof­it not only from invest­ing in stocks he likes but also prof­it from short­ing stocks he dis­likes. Whether or not the port­fo­lio man­ag­er is any good at iden­ti­fy­ing those indi­vid­ual win­ners and losers will ulti­mate­ly deter­mine the suc­cess or fail­ure of such a strat­e­gy.

That said, it is com­mon for long/short strate­gies to have cer­tain bias­es reflect­ed in their port­fo­lio. These bias­es might involve val­u­a­tions, sec­tors, cap­i­tal­iza­tion, or any oth­er type of quan­tifi­able fac­tors. For exam­ple, if a port­fo­lio man­ag­er is fun­da­men­tal­ly a val­ue investor, one would like­ly see val­ue names held long and growth stocks short­ed. This kind of port­fo­lio would be dou­bly exposed to its fac­tor bets, which is great if the fac­tor is in favor but poten­tial­ly dis­as­trous if it is out of favor.

Risks

As any sophis­ti­cat­ed ana­lyst knows, return and risk are two sides of the same coin: if the returns of a long/short fund are dri­ven by the port­fo­lio manager’s stock picks, so will be the risks. The port­fo­lio man­ag­er will live or die on their abil­i­ty to iden­ti­fy in advance the indi­vid­ual win­ners and losers.

If the port­fo­lio reflects a cer­tain fac­tor bias, that bias could help or hurt depend­ing on whether or not it is in favor. To return to our pre­vi­ous exam­ple, imag­ine a port­fo­lio man­ag­er has a val­ue bias. A long-only val­ue port­fo­lio will trail the mar­ket in a year when growth is in favor, like 2017 or 2015. How­ev­er, the long/short val­ue man­ag­er who is long val­ue stocks and short growth stocks would be dou­bly exposed to such a fac­tor bet.

Because port­fo­lio man­agers are uncon­strained in a long/short strat­e­gy and can essen­tial­ly dou­ble their bets, the per­for­mance across long/short funds varies wide­ly. The dis­per­sion between “first and worst” can be quite wide. It is dan­ger­ous to use “the aver­age long/short” fund as a proxy for the asset class when the returns and risks are so diver­gent. The table below illus­trates this:

Dispersion First and Worst - DRS vs Long.Short Strategies - Swan Blog

Source: Morn­ingstar Direct, Zephyr StyleAD­VI­SOR. Annu­al­ized return, beta, and R2 were cal­cu­lat­ed vs. the S&P 500 and only for those 71 funds with a three-year track record as of 9/30/17.

 

While the dis­per­sion in per­for­mance is wide, long/short man­agers do tend to share cer­tain ten­den­cies. Long/short man­agers tend to have high­er than aver­age expense ratios and trade more fre­quent­ly. Accord­ing to Morn­ingstar, the medi­an long/short man­ag­er has an annu­al turnover ratio of 163%, and the most active fund has an eye-water­ing turnover ratio of 7,042%. It is fair to say an investor must have a lot of faith in that par­tic­u­lar manager’s process in order to jus­ti­fy a turnover ratio of 7,042%.

Role Within a Portfolio

It is often said that alter­na­tives per­form one of two roles with­in a port­fo­lio: they are either “alpha dri­vers” or “beta reduc­ers.” Depend­ing on the indi­vid­ual long/short man­ag­er, they can fill either role. In the pre­vi­ous table, we saw how the sen­si­tiv­i­ty to the mar­ket, as mea­sured by beta and R-squared, varies wide­ly from fund to fund. These num­bers should help the ana­lyst deter­mine which role an indi­vid­ual long/short man­ag­er might play with­in a port­fo­lio.

How do long/short strategies compare to the Defined Risk Strategy?

Com­pared to the typ­i­cal long/short man­ag­er, the Defined Risk Strat­e­gy (DRS) approach­es the mar­ket from the oppo­site end of the spec­trum. While the over­all goal is rough­ly the same—to pro­duce respectable absolute returns through bull and bear markets—the way they seek to accom­plish that goal is com­plete­ly dif­fer­ent. One of the fun­da­men­tal pre­cepts of the DRS is that it is dif­fi­cult, if not impos­si­ble, to iden­ti­fy those stocks that will out­per­form or under­per­form on a con­sis­tent basis. In con­trast, a long/short fund’s entire val­ue propo­si­tion is based upon invest­ing long out­per­form­ing stocks and short­ing under­per­form­ing stocks.

The DRS wants its mar­ket expo­sure to be as broad as pos­si­ble. It uti­lizes broad and liq­uid ETFs to gain robust cov­er­age of an asset class. Risk is man­aged by uti­liz­ing broad-based options on those same asset class­es. The DRS’s pri­ma­ry dri­vers of returns are its buy-and-hold mar­ket expo­sure, its hedg­ing, and its pre­mi­um col­lec­tion.  All three of these com­po­nents are at an asset class lev­el and are designed to pro­vide val­ue in dif­fer­ent types of mar­kets (i.e. ris­ing, falling, or flat, respec­tive­ly). The DRS can be described as a “top-down” man­ag­er where­as a long/short approach is the epit­o­me of a “bot­tom-up” style.

Because the val­ue propo­si­tions of a typ­i­cal long/short man­ag­er and the DRS are so fun­da­men­tal­ly dif­fer­ent, a case could be made for pair­ing the two togeth­er. The two approach invest­ing in such dif­fer­ent ways that they could form a com­ple­men­tary part­ner­ship. Specif­i­cal­ly, a long/short fund with more upside mar­ket cap­ture and high­er beta could be a nice poten­tial can­di­date for pair­ing with the DRS, since the DRS has tra­di­tion­al­ly been used in a risk-reduc­ing role. This would be an exam­ple of com­bin­ing an “alpha dri­ver” with a “beta reduc­er.”

 

About the Author:

Marc Odo, Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Director of Investment Solutions - Swan Global InvestmentsMarc Odo, CFA®, CAIA®, CIPM®, CFP®, Direc­tor of Invest­ment Solu­tions, is respon­si­ble for help­ing clients and prospects gain a detailed under­stand­ing of Swan’s Defined Risk Strat­e­gy, includ­ing how it fits into an over­all invest­ment strat­e­gy. For­mer­ly, Marc was the Direc­tor of Research for 11 years at Zephyr Asso­ciates.

 

 

 

Impor­tant Notes and Dis­clo­sures: Swan Glob­al Invest­ments, LLC is a SEC reg­is­tered Invest­ment Advi­sor that spe­cial­izes in man­ag­ing mon­ey using the pro­pri­etary Defined Risk Strat­e­gy (“DRS”). SEC reg­is­tra­tion does not denote any spe­cial train­ing or qual­i­fi­ca­tion con­ferred by the SEC. Swan offers and man­ages the DRS for investors includ­ing indi­vid­u­als, insti­tu­tions and oth­er invest­ment advi­sor firms. Any his­tor­i­cal num­bers, awards and recog­ni­tions pre­sent­ed are based on the per­for­mance of a (GIPS®) com­pos­ite, Swan’s DRS Select Com­pos­ite, which includes non-qual­i­fied dis­cre­tionary accounts invest­ed in since incep­tion, July 1997, and are net of fees and expens­es. Swan claims com­pli­ance with the Glob­al Invest­ment Per­for­mance Stan­dards (GIPS®).

All Swan prod­ucts uti­lize the Defined Risk Strat­e­gy (“DRS”), but may vary by asset class, reg­u­la­to­ry offer­ing type, etc. Accord­ing­ly, all Swan DRS prod­uct offer­ings will have dif­fer­ent per­for­mance results due to offer­ing dif­fer­ences and com­par­ing results among the Swan prod­ucts and com­pos­ites may be of lim­it­ed use. All data used here­in; includ­ing the sta­tis­ti­cal infor­ma­tion, ver­i­fi­ca­tion and per­for­mance reports are avail­able upon request. The S&P 500 Index is a mar­ket cap weight­ed index of 500 wide­ly held stocks often used as a proxy for the over­all U.S. equi­ty mar­ket. Index­es are unman­aged and have no fees or expens­es. An invest­ment can­not be made direct­ly in an index. Swan’s invest­ments may con­sist of secu­ri­ties which vary sig­nif­i­cant­ly from those in the bench­mark index­es list­ed above and per­for­mance cal­cu­la­tion meth­ods may not be entire­ly com­pa­ra­ble. Accord­ing­ly, com­par­ing results shown to those of such index­es may be of lim­it­ed use. The adviser’s depen­dence on its DRS process and judg­ments about the attrac­tive­ness, val­ue and poten­tial appre­ci­a­tion of par­tic­u­lar ETFs and options in which the advis­er invests or writes may prove to be incor­rect and may not pro­duce the desired results. There is no guar­an­tee any invest­ment or the DRS will meet its objec­tives. All invest­ments involve the risk of poten­tial invest­ment loss­es as well as the poten­tial for invest­ment gains. Pri­or per­for­mance is not a guar­an­tee of future results and there can be no assur­ance, and investors should not assume, that future per­for­mance will be com­pa­ra­ble to past per­for­mance. All invest­ment strate­gies have the poten­tial for prof­it or loss. Fur­ther infor­ma­tion is avail­able upon request by con­tact­ing the com­pa­ny direct­ly at 970–382-8901 or www.swanglobalinvestments.com108-SGI-030118

By | 2018-03-02T10:53:42+00:00 March 1st, 2018|Blog|Comments Off on DRS vs. Long/Short Strategies