Financial Advisors

2017 Review of the Long/Short Equity Hedge Fund Space

By Kevin Hurd and Steve Togher for Cross Shore Capital Management

Long/short equity hedge funds finished 2017 with their best year since 2013, delivering an average return of 13.3%[i]. The funds we allocate to had comparable returns, while maintaining an average net exposure of approximately 55%. Their average volatility was lower than the S&P 500 and positive returns were generated across several different market sectors.

The environment significantly improved for fundamentally driven strategies during the year, relative to previous years, due in part to lower correlations across different market sectors and stocks in general (see chart 1).

This allowed skilled stock pickers to identify long positions in undervalued companies that seemed likely to increase in price, while at the same time, taking short positions in companies that were overvalued and likely to go down. Long/short equity managers will sometimes hedge their portfolios against broad market moves by taking short positions in market indices, including the S&P 500, Russell 2000 and the Nasdaq. As you might expect, those positions lost money as the markets had strong gains during the year.

Chart 1

Inter-Sector Correlation

 

 

 

Source: Credit Suisse, Business Insider

We observed a large difference in performance of growth stocks relative to value stocks in 2017, where the S&P 500 Growth Index was up 27.4% on the year versus 15.4% for the S&P 500 Value Index. Biotech and Information Technology stocks also had a strong year with their respective indices gaining 43.9%[ii] and 38.8%[iii]. The results for long/short equity hedge fund managers reflected this trend. Growth-biased managers returned 18.8%[iv]on the year while value-biased managers returned 13.5%[v]. Healthcare and Technology managers returned 16.8%[vi] on average.

2018 began as a continuation of 2017, with good performance in January, as the average long/short equity hedge fund manager returned 3%. Growth continued to outperform value and, as expected, growth-biased hedge fund managers outperforming value-biased managers. The year began with the average correlation between S&P 500 stocks at a 23-year low (see chart 2) and expectations of more Fed funds interest rate hikes throughout the year[vii].

After almost a decade of central bank activity that kept interest rates artificially low and borrowing costs down, it appears we have entered a market environment that will be driven more by company specific fundamentals.  The resulting “two-sided market”, where good companies increase in value and poor ones go down bodes well for long/short equity hedge funds.

Chart 2

Average Pairwise Correlation of All S&P 500 Stock Combinations

 

 

Source: S&P, BofAML Global Research, KKR

The long/short equity hedge fund managers that we allocate to generally remain positive on equity markets and believe the economy continues to look robust with job growth, low unemployment, and tax cuts all boding well for public equities. However, they also remain cognizant of the potential for a shift in the investment environment due to increased inflation expectations and unexpected rate increases.

This dichotomy is just another example of why we continue to believe that a hedged strategy is the best way to materially participate in rising equity markets while providing downside protection.

[i] HFRI Equity Hedge (Total) Index

[ii] S&P Biotechnology Select Industry Index

[iii] S&P 500 Information Technology Index

[iv] HFRI EH: Fundamental Growth Index

[v] HFRI EH: Fundamental Value Index

[vi] HFRI EH: Sector -Technology/Healthcare (Total) Index

[vii] Bloomberg

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

Cross Shore Capital Management

Cross Shore Capital Management, LLC (“Cross Shore”) was founded in November 2002 and manages funds of hedge funds focusing on long/short equity managers.

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