Consider long/short equity as the business cycle matures

Long/short equity approaches have historically outperformed the market during later periods of the business cycle—and late-cycle indicators are mounting right now.

Consider long/short equity as the business cycle matures

Key points

  • During the late stage of the business cycle, we believe initiating or increasing an allocation to long/short equity approaches may help enhance portfolio returns and reduce market risk.
  • Long/short strategies can modulate net market exposure, using a broad tool kit to potentially generate excess returns and smooth the effects of stock price volatility.
  • We find sector-specific long/short equity to be attractive, especially in areas with broad dispersion and structural tailwinds, such as financials, healthcare, and technology.

Long/short equity approaches, with their ability to modulate net exposure and take calculated risks designed to generate excess returns—in up or down markets—have historically outperformed long-only equities during later periods of the business cycle. In examining the asset allocation implications for investor portfolios, we believe now is a particularly good time to consider increasing exposure to long/short equity. Late-cycle indicators are mounting: Corporate earnings have been strong, and valuations are elevated. Market volatility has been on the rise, and we expect stock price dispersion to increase. Interest rates are ticking up and inflation expectations have begun to follow. Given the prolonged regime of low interest rates and the recent infusion of fiscal stimulus, we believe the current cycle could be an extended one, with the late-stage environment potentially persisting 12 to 18 more months. As we approach the most mature stages of this business cycle, investors may want to initiate or add exposure to total-return, growth-oriented strategies that have the potential to enhance performance and reduce downside risk.    

What has driven—and what hasn’t driven—late-cycle market movements

The three components of equity returns—earnings growth, valuations, and dividend yield—tend to ebb and flow throughout each business cycle. In 2017, corporate earnings dominated equity performance, contributing meaningfully to total returns. This provides a clue as to where we are today.    

Earnings had a big impact on returns last year

Historically, earnings have had a greater effect on performance as the business cycle progresses. In such environments, using fundamental analysis to identify companies with strong free-cash-flow generation becomes essential, in our view. Relying on broad-based multiple expansion may work during the recovery stage, but these tactics tend to become much less effective later on, when valuations contract and ultimately detract from performance.    

Earnings tend to dominate returns late in the business cycle

Market volatility has been appreciably higher since the beginning of the year, and we think is likely to continue throughout 2018. Against this backdrop, we expect stock dispersion to expand as well, in part because of the new U.S. tax law, which will benefit some companies and industries more than others, and in part because this tends to occur in the late stages of the business cycle. Putting it all together, while fundamentals remain strong and economic data largely positive, the crosscurrents of rising volatility, interest rates, and inflation have appeared, leading us to examine how to effectively position investor portfolios for late-stage conditions over the near to medium term.

Market volatility bottomed in 2017

Long/short equity may help your portfolio late in the business cycle

Part of our big-picture investment policy work involves thinking about how different assets may perform relative to one another in various market or economic environments. A growing body of research shows that the late-cycle backdrop has historically been favorable for long/short equity approaches. While long-only equities tended to outperform during the recovery and expansion phases, long/short equity outpaced them during both late-stage and bust periods, delivering better returns and a greater degree of downside protection. This is true on both a total-return basis, and a market risk-adjusted basis.

Long/short equity has outperformed long-only in late-state environments

With a tendency to exhibit lower correlations with the market—and high active share measures—long/short approaches may help clients diversify a portfolio’s equity exposures and sources of returns. In our view, this asymmetry can be particularly beneficial in periods of volatility.

Long/short excess returns have been highest in late-stage periods

Adjusting for beta, or market exposure, long/short approaches have also delivered more attractive performance during the later stages of the business cycle, providing a relative balance of a portion of the market’s exposure, along with alpha, or excess returns over the market.

Sector-specific approaches provide interesting opportunities

We find sector-specific long/short approaches to be particularly attractive. Many global sectors are extremely broad, with extensive dispersion across the best- and worst-performing stocks, making certain specific sectors fertile ground for skilled, specialist active managers to potentially generate alpha. In addition to breadth and dispersion, we look for sectors where structural tailwinds are in place. In our view, some of the sectors with the more attractive opportunities for long/short managers today are financials—particularly U.S. banks—information technology, and healthcare.

“… some of the sectors with the more attractive opportunities for long/short managers today are financials—particularly U.S. banks—information technology, and healthcare.”

With U.S. financials, continued deregulation, the recent tax reform, and rising interest rates combine to create a potentially lasting tailwind. This is a huge sector with low intra-sector cross correlations. In information technology industries, such as digital payments, cloud computing, the Internet of Things—IoT—and artificial intelligence—AI—have the potential to create superior and inferior business models in many sectors—not just technology. The automotive industry, financial services, life sciences and healthcare, manufacturing, and consumer sectors will increasingly feel the reach of technology’s long and strong robotic arm. Healthcare is an enormously complex sector historically marked by broad dispersion and low intra-sector correlations. Favorable demographic trends are boosting demand growth, unprecedented levels of innovation are fueling the biotechnology industry, and new delivery models are changing the landscape for healthcare services.    

Make long/short equity a part of your late-cycle action plan

As the global economy recovered from the great financial crisis and moved into expansion, long-only strategies generally outpaced long/short approaches. With the MSCI AC World Index and S&P 500 Index delivering annualized returns of 9.4% and 13.0%, respectively, for the past five years (as of April 30, 2018), investors were largely able to meet their return objectives with long market exposure alone. But as the business cycle continues to advance to a more mature stage, likely ushering in a period of higher stock dispersion and market volatility, we think it’s time for investors to consider strategies that offer excess return potential and flexible net market exposure. Equity long/short approaches can be an attractive complement to long-only strategies. During late-stage periods in particular, we believe that increasing an allocation to long/short strategies makes sense for investors seeking to enhance portfolio returns, reduce risk, or both.

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Note: It is not possible to invest directly in an index.
The Credit Suisse Long/Short Equity Index tracks the asset-weighted performance of more than 5,000 funds using directional equity-oriented strategies, investing on both the long and short sides of the market.
The Hedge Fund Research Equity Hedge Total Index tracks the performance of funds that maintain both long and short positions primarily in equity and equity derivative securities.
The JPMorgan Global Manufacturing PMI tracks national contributions to global manufacturing. Country weights for the global indices are derived from the latest available World Bank data on the gross value added for each of the nations covered.
The MSCI All Country (AC) World Index tracks the performance of publicly traded large- and mid-cap stocks of companies in 23 developed markets and 24 emerging markets. Total returns are calculated gross of foreign withholding tax on dividends.
The MSCI Emerging Markets (EM) Index tracks the performance of publicly traded large- and mid-cap emerging-market stocks.
The MSCI Europe ex UK Index tracks the performance of publicly traded large- and mid-cap stocks of 14 European countries, excluding the United Kingdom.
The MSCI Japan Index tracks the performance of publicly traded large- and mid-cap stocks in Japan.
The MSCI United Kingdom Index tracks the performance of publicly traded large- and mid-cap stocks in the United Kingdom.
The MSCI USA Index tracks the performance of publicly traded large- and mid-cap stocks in the United States.
The MSCI World Index tracks the performance of publicly traded large- and mid-cap stocks of developed-market companies. Total returns are calculated gross of withholding tax on dividends.
The Organisation for Economic Co-operation and Development (OECD) Leading Economic Indicators attempt to identify turning points in economic activity relative to trend six to nine months ahead by tracking a broad basket of economic data.
The S&P 500 Index tracks the performance of 500 of the largest publicly traded companies in the United States.