Long/Short Equity: Quantitative Versus Fundamental
Long/short equity is among the most popular investment strategies used by hedge fund managers, primarily because it is a straightforward and effective way to hedge market risk. Similar to stock picking, funds invest in equities that they believe will increase in value over time while simultaneously selling short positions they believe will decrease in value.
Traditionally, long/short equity funds average 35 to 40 percent net long, indicating a bullish outlook. Recently, however, we have seen that percentage dip well below the historical average due in large part to the guarded nature of today’s investors.1
However, many managers are doing more to protect themselves against downturns than rebalancing their portfolios. To fight against negative market trends, more and more hedge fund managers are pursuing fundamental strategies. Apparently, this is just what investors want.
In May, 45 percent of the investors we spoke to expressed a preference for fundamental mangers while 30 percent favored quantitative managers. This difference could be attributed to the fact that fundamental approaches have outperformed their quantitative counterparts during the past few years.
However, BHA’s conversations with investors point to other reasons. Many investors note that long/short strategies are easier to understand and fundamental managers provide more transparency. Investors are reluctant to invest in something they don’t understand and many feel quantitative strategies are too complicated.
Additionally, almost half of the investors we spoke to in May required at least quarterly liquidity, and an astonishing 99 percent required an experienced management team with a proven track record. Investors want access to their money and they want to work with teams they can trust. The plethora of Ponzi schemes and fund meltdowns over the past few years has diminished investor’s willingness to take risks.
Although most quantitative strategies may be difficult to understand, they can potentially provide better downside protection and characteristically have lower operational fees. Therefore, an argument can be made for combining a fundamental approach with a cheaper, more defensive model that employs sophisticated mathematical tools able to sift through copious amounts of data in seconds. The fact that there isn’t an uptick in quantitative interest during such volatile times, however, implies that current investors prefer fundamental reasoning and analysis when it comes to picking stocks.
As always, long/short equity strategies will remain a popular choice among hedge fund investors for the foreseeable future. However, BHA expects more management teams will combine both fundamental and quantitative models in order to maximize upside potential while mitigating risk.
1 Market Folly, “Long/Short Equity Hedge Funds: Net Long Exposure Below Average,” April 21, 2010.