Third Quarter 2019 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 entered the third quarter coming off a very strong first half of the year. The average fund returned 9.3% in the first half of 2019 (HFRI Equity Hedge (Total) Index) and, at Cross Shore, we observed significant alpha generation on both the long and the short sides of the portfolio for the managers we allocate to. However, there were several potential headwinds on the minds of managers as we entered the second half of the year. These included questions on where the Federal Reserve would take interest rates, the ongoing trade negotiations between the US and China, the continued global economic slowdown, and the continued dispersion between growth and value. Spreads between gross and net exposures were historically high entering the quarter, indicating high conviction in both long and short portfolio positions but also a healthy skepticism of where broad equity markets could potentially go in the second half of the year.
The third quarter was mixed for broad equity markets. The S&P 500 returned 1.7%, the MSCI World and Nasdaq were flattish, and the Russell 2000 declined 2.4%. It was a very choppy market with significantly increased volatility versus the first half of the year. The VIX doubled during the quarter and hit its year-to-date high in late August as trade war rhetoric intensified and the yield curve briefly inverted. In September there was a massive rotation out of growth stocks and into value stocks and the US House of Representatives initiated an impeachment inquiry into President Trump.
It turned out to be a challenging quarter for many long/short equity hedge funds, with the average manager down 1.1%, although the dispersion in returns among managers was very high. For example, among the managers we allocate to at Cross Shore, we saw up to a 10% spread in the returns between positive and negative performance. Managers with substantial exposure to high growth technology stocks experienced the most difficulty, which in many cases were some of the industry’s best performing funds prior to the September rotation. Software companies, commonly referred to as SaaS (Software as a Service) with high multiples were hit the hardest, with software stocks in general down 3% for the quarter (S&P Software & Services ETF) and some of the highest growth names down as much as 30% peak to trough. These high growth sell-offs tend to occur after a period of strong performance as this attracts momentum investors and quant strategies who push stock prices higher but then exacerbate selling once a trigger event occurs.
Healthcare sector-focused managers also had a difficult quarter, down 5.8% on average (HFRI EH: Sector – Healthcare). This was mainly driven by biotech stocks which were down 13.1% for the quarter (S&P Biotech ETF). Many biotech investors attribute this to Elizabeth Warren’s rise in election polls and believe it is a similar phenomenon to the 2016 election when Hillary Clinton’s progressive healthcare agenda was on investors’ minds. Biotech stocks fell roughly 45% from September 2015 through February 2016, following a Hillary Clinton tweet vowing a plan to end drug price “gouging.”
Looking ahead to the fourth quarter, while some potential headwinds remain, the majority of the long/short equity managers we speak with are optimistic. They expect a strong earnings season, believe the sell-off in high growth software stocks is overdone and those stocks will rebound, and believe a recession is unlikely in the near-term. A theme that has emerged is playing the growth to value rotation, which many managers believe will be longer lived rather than a short-term event. Despite the general optimism, net exposure levels largely continue to be more conservative. At Cross Shore, we continue 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.