Sector dispersion creates opportunities for long/short equity funds

The COVID-19 pandemic’s impact on different parts of the economy has created big gainers and decliners among individual sectors ranging from biotechnology stocks to airlines. Known as sector dispersion, it can spell opportunity for long/short equity funds. However, it’s important for investors to understand how these strategies work because, like sectors, the performance of individual long/short equity funds can be all over the map. 

sector-dispersion-long-short-equity-funds

Long/short equity funds often come into focus during volatile markets, as we discussed in a recent viewpoint. That’s because they may provide some downside protection due to their lower net exposure/beta profile and their short positions, which can profit from falling markets. Yet funds within the long/short equity category can take very different approaches, so performance can vary.

A sector-based approach

We favor a flexible sector-based approach to long/short equity, and we believe the current market provides a rich hunting ground due to sector dispersion. However, we also tend to favor a long-term approach to sector investing based on secular trends, rather than jumping quickly in and out of sectors.

sector-performance-chart

Getting sectors right can lead to long-term outperformance; for example, over the past five years, the S&P 500 Information Technology Index has posted a five-year annualized return of 21.2%, compared with a loss of 11.2% for the S&P 500 Energy Index. The S&P 500 Index itself has a five-year annualized return of 9.0%.¹

Having the ability to dial net exposure up or down (long versus short exposure) can also affect performance, which is why we favor a flexible, or unconstrained, approach in long/short equity strategies.

Flexibility within sectors is key

Right now, we believe three sectors are poised to benefit from secular trends in the economy: healthcare, technology, and financials. Further, we believe there will be potential winners and losers within those sectors, both at the subindustry and single stock levels.

In the United States, there are 11 major sectors, yet each sector has its own industry groups and individual subindustries.

For example, the financials sector can be broken down into banks, insurers, and diversified financial companies—and each of those industry groups is further subdivided into individual industries. So within sectors, we think some subindustries are better positioned than others. 

Healthcare: a sector benefiting from secular trends

Healthcare is a complex sector with a wide range of subsegments, including biopharmaceuticals, healthcare services, and medical technology. Each of these subsegments has varying drivers leading to different performance. From a tailwind perspective, we’ve seen growth in the introduction of innovative new treatments (e.g., gene therapy, immuno-oncology, and gene editing) and an aging demographic. 

healthcare-sector-industry-groups

Among the Organization for Economic Cooperation and Development (OECD) countries, healthcare spending as a percentage of GDP increased 25% between 2000 and 2017,² and this growth in spending is expected to continue. Headwinds that may affect these businesses could come from drug pricing risk, patent cliffs, or relying on outdated business models. To understand and identify healthcare companies often requires the investor to understand the science behind the drugs. We believe the tailwinds outweigh the headwinds, but together they create a sector with individual companies best identified by a sector specialist.

Finding opportunities in tech and financials

One of the biggest market trends in recent years is the outperformance of the tech sector and the underperformance of the financials sector; this trend is also playing a big role in the growth versus value debate.

Looking at financials, this has been a sector that’s faced challenging returns and high levels of volatility over the last decade. Similar to healthcare, financials is a complex sector with complex balance sheets, lending itself to specialists, rather than generalists. Financials can also be affected by outside factors, such as the benefits from both the recent tax cuts and deregulation, but also challenged from the low interest-rate environment.

Meanwhile, technology has a far reach and continues to disrupt sectors. Digital payments, cloud computing, the Internet of Things, and artificial intelligence have the potential to create winning and losing business models in many sectors—not just IT; for example, financial services and retail are increasingly being disrupted by technology. Today, over 80% of global commerce is still done in physical retail stores, according to 2019 data from Digital Commerce 360. By definition, every transaction that shifts to e-commerce paid for digitally. Within banking, the infrastructure is old―most systems were developed over 30 years ago, and banks with outdated systems may find it harder to compete with new entrants. In the United States and other big markets such as Western Europe, banks have had to spend tens of billions of dollars on technology and processes since the 2008 global financial crisis, but only to satisfy regulators and clean up their back offices.

The automotive industry, life sciences and healthcare, manufacturing, and consumer market segments will also increasingly feel the effects of technology.  

The long and the short of it

Healthcare, technology, and financials are among the sectors that are seeing performance diverge as the pandemic affects different areas of the economy. We believe long/short equity strategies can take advantage of this trend while also providing diversification and some downside protection in declining markets.

 

1 S&P Dow Jones Indices, as of 7/21/20. 2 stats.oecd.org, 7/21/20.