If you ever consider investing in equities, then a long/short strategy might offer you a better opportunity than a traditional long only allocation.
The chart below tracks the average returns of an index of long/short equity funds (Barclays) since 1994.
Clearly in the market downturns of 2002 (1) and 2008 (2), long/short strategies behaved much better than equity indices. The Barclays benchmark not only significantly outperformed the S&P but did so with less volatility. Drawdowns in hard times were milder by approximately half.
Further, the long/short strategies showed greater resilience. Recovery periods were respectively 55 and 43 months shorter than those of the S&P Index in those bear markets.
Long/short managers are flexible and naturally tend to increase their net long exposure in rising markets and defensively diminish their net exposure in bearish ones. This provides adaptive protection for the strategy and partially explains its insignificant underperformance in rising markets.
The nature of a long/short strategy obliges a manager to consider stocks not only with a view to gains in a bull market but also their potential to profit in a bear market. This adds a layer of discipline requiring focus on an asset's undervaluation/overvaluation, which can lead to a stricter selection process and improved performance.
Nevertheless, increasing speculation preceding a bear market may distort the value of a long/short approach. Because its positions are build mostly on sound fundamentals, irrationality in the markets can create an obstacle to performance as it did in 1999 during the heady days of the tech bubble
During the 23 year period represented in the chart, long/short equity offered an advantage over a long-only approach more than 60% of the time. This outperformance is typical of market fall and recovery stages, while underperformance is normal for a mature growth stage of the market.
In the late stage of an economic cycle a frequent alternation of out/under performance should not discourage investors, as the inevitable bear market will bring again the advantage of a long/short approach. In the early stages of a cycle, when nobody can know the real bottom, long/short equity offers a prudent path to entering the market.
In sum, long/short equity can provide us with a more conservative option to invest in the stock market while bringing a significantly superior risk/reward ratio than long-only investing.
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