Long/Short Equity Complements Equity & Fixed Income Allocations
One of the greatest threats that investors face is the necessity to take distributions from a portfolio during times of market distress. A Long/Short Equity allocation can help reduce that risk though the following advantages:
Bear markets are an inevitable part of investing, and they are difficult to predict. For many investors, a large loss of capital can be devastating to their goals. Many investors will have time to dig out from losses, but it can take years to recover from significant losses.
In the last bear market of 2007-2009, the S&P 500 index lost 57 percent of its value. However, during the financial crisis, the average long/short equity strategy lost about 20 percent.
As a loss grows, portfolio recovery relies on an even larger return to recover. A 57 percent loss, such as that experienced by the S&P 500 Index, would require a 132 percent gain to recover losses. By comparison, the 20 percent loss experienced by long/short equity managers would require a 25 percent return to recover losses.
If a portfolio experienced a 20% loss and then 10% gains each year, it would take nearly 3 years for that portfolio to recover. Meanwhile, if a portfolio had a 57% loss and then the same 10% gains each year, it would take that portfolio nearly nine years to gain back its value before the loss. By reducing the volatility in a client’s portfolio, you can help them meet their financials goals, when they want to meet them.
As volatility in the market rises, clients, and even advisors, are more likely to want to take risk off the table by selling positions and moving to cash. However, research has proven that investors who stay the course are more likely to outperform than investors that try to time the market. Even those that successfully time the market typically reap only marginal gains, but they risk missing out on market upswings.
One of the ways to help keep clients invested is to reduce the volatility that causes them to make a run to safety. With a portfolio that is built on the basis of preserving wealth without forgoing market gains, you have a greater chance of participating in market upswings and protecting against the downside, without the risk of trying to time the market.
The other advantage to reducing volatility is that, over a full market cycle, lower volatility leads to higher compounded returns. Below shows the impact of volatility on compounded returns. Each portfolio has a simple average return of 10%, but higher volatility lowers the resulting compounded return.
Long/Short equity strategies target lower volatility than the broader market by offsetting long market exposure with short positions. By combining long/short equity with a traditional allocation, an investor can target the right amount of volatility to keep them on track towards meeting their goals.
According to Modern Portfolio Theory (“MPT”), investors can reduce risk and enhance returns by combining asset classes that are not highly correlated. This is also known as diversifying a portfolio. Historically, portfolios that are made up of stocks and bonds have worked to smooth out volatility because of their low correlation with each other. In the same way, Long/Short equity can continue to enhance the traditional allocation of stocks and bonds because of its lower correlation to both asset classes.
Over the last twenty years, from July 1, 1998 to June 30, 2018, adding long/short equity to a traditional 60/40 portfolio improved the risk/reward for investors. A portfolio that added a 20% allocation to long/short equity reduced the standard deviation (-18%) and maximum drawdown (-17%) versus the traditional 60/40 portfolio.
Past performance is not an indication of future results. The analysis above is provided for information only and is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad-based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation by Waycross Partners, LLC to buy, sell or hold such investments. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.