Second Quarter 2019 Review of the Long/Short Equity Hedge Fund Space
By Kevin Hurd and Steve Togher for Cross Shore Capital Management
The second quarter was another positive quarter for equity markets broadly, albeit with softer gains than Q1 and with a sharp sell-off thrown into the mix during the month of May. The S&P 500, MSCI World, Nasdaq, and Russell 2000 indices returned 4.3%, 3.4%, 3.6%, and 2.1%, respectively. Long/short equity hedge funds also generated positive returns for the quarter, up 1.8% on average (HFRI Equity Hedge (Total) Index) and did a nice job protecting on the downside in May, down only 1% on average while broad equity market indices were down over 6%. We continued to see skilled managers generate strong alpha on both the long and short sides of their portfolios, like we saw during Q1.
Technology sector-focused funds performed especially well during the quarter, up 2.9% on average (HFRI EH: Sector-Technology Index). More directional technology-focused managers, with net exposures of 50% or higher performed the best. The leading sub-sector in technology that drove performance for the managers we allocate to was SaaS (software as a service). This is a group of companies that tend to provide on-demand software, centrally hosted, using a licensing and delivery model on a subscription basis, and is a part of the larger cloud computing industry. Until recently, SaaS companies were considered too expensive for many growth-oriented investors (and value-oriented investors wouldn’t event look at them) but recent IPOs like Zoom (ZM) joining other leading SaaS companies including Okta (OKTA) and Coupa (COUP) has made the sub-sector more attractive to a broader range of investors. The underlying theme we are hearing from the managers we allocate to is market penetration. Despite trading at 9.5x forward multiples by some measures, these firms are just scratching the surface on building out their client bases. However, stock selection is key. Many SaaS companies do not measure up to expectations and stock price volatility is high.
Healthcare and biotechnology were two other areas where we saw managers meaningfully outperform market and industry indices. While the average healthcare sector-focused manager was down 0.1% for the quarter (HFRI EH: Sector – Healthcare Index), the most skilled managers in the space did much better, in the range of 4% to 11% for the managers we allocate to. Stock selection, long and short, and managing gross and net exposure were the key drivers. There is very high volatility and binary-risk in the biotech sector. Binary-risk is usually associated with the outcome of a clinical trial or regulatory judgement. If a trial goes well the stock can skyrocket, like the case of La Jolla Pharma (LJPC) last month. On the other hand, get bad news and the stock can really tank, like inflaRX (IFRX). That is why a combination of financial investing expertise and scientific expertise is critical to the success of long/short equity hedge funds investing in the biotech space.
The first half of 2019 was very strong for long/short equity hedge funds with the average fund returning 9.5%. It was stock picker’s market and we saw substantial alpha generated on both the long and short sides of the portfolios of the managers we invest with. While most managers we speak with continue to be optimistic in the near-term, they are also cognizant that the uncertainty around global trade policy will remain a headwind. Many managers expect a much choppier environment in the second half of the year, an environment which could potentially create opportunities for skilled stock pickers and traders. Cross Shore continues to believe that a hedged strategy is the best way to materially participate in rising markets while providing downside protection.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.