Economy

Second Quarter 2018 Review of the Long/Short Equity Hedge Fund Space

By Kevin Hurd and Steve Togher for Cross Shore Capital Management

Equity markets rebounded nicely in the second-quarter of 2018, following a challenging February and March. The S&P 500 Total Return Index returned +3.4% for the quarter, moving back into the black for the year, up +2.7% year-to-date. Growth stocks continued their multi-year outperformance of value stocks, as the S&P 500 Growth Index returned +5.3% for Q2 and is up +7.3% year-to-date while the S&P 500 Value Index returned -1.4% and is down -2.2% for the year.

Long/short equity hedge funds saw wide dispersion in performance during the quarter. Healthcare and technology sector-focused managers had a very strong Q2, generating average returns of +6.5%[i] and +4.7%[ii] respectively.  Cross Shore observed that managers with meaningful exposure to small and mid-cap stocks also performed well for the quarter, in line with the Russell 2000, which was up was up +7.8%.

Conversely, we observed that managers with significant emerging markets exposure had difficult quarters, which was not surprising with the MSCI Emerging Markets Index down -8.7%. Quantitative strategies also continued to struggle, down -0.2% in Q2 and down -1.0% year-to-date[iii].

Given the mix of results among the various long/short equity sub-strategies, it’s wasn’t surprising to see the broader HFRI Equity Hedge (Total) Index return +0.9% for the quarter, bringing its year-to-date performance to +1.2%.  Manager and strategy selection have been paramount to generating alpha for long/short equity hedge fund allocators in the current market environment.

The managers we allocate to at Cross Shore generally continue to have a positive outlook on the US economy and believe the risk of recession remains relatively low. They cite several tailwinds that support continued economic growth including recent tax and regulatory reforms, a strong US consumer, and stable inflation. However, our underlying managers also remain cognizant of possible changes to the economy and how they could potentially impact their portfolios.

These include sector rotation (growth to value for example), the impacts of tariffs on trade, Fed rate increases, a tight labor market and corresponding wage inflation, and a flattening yield curve, which historically has been a good indicator of an impending recession.

Cross Shore continues to believe the investment environment for long/short equity hedge funds is positive and will continue to improve. Stock correlations are down significantly from where they were during much of the current bull market, long/short equity hedge funds have historically done well in a rising interest rate environment, and we have seen a return of more normalized overall stock market volatility.

All these factors should provide an advantage to skilled stock pickers on both the long and short sides of their portfolios.  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 EH: Sector – Healthcare Index

[ii] HFRI EH: Sector – Technology Index

[iii] HFRI EH: Quantitative Directional Index

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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