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.
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.
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.
Among the Organisation for Economic Co-operation 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. Understanding and identifying 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 is 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.
The views expressed are those of the author(s) and are subject to change. No forecasts are guaranteed. This commentary is provided for informational purposes only and is not an endorsement of any security, mutual fund, sector, or index.
The S&P 500 Index tracks the performance of 500 of the largest publicly traded companies in the United States. The S&P 500 Information Technology Index tracks companies in the S&P 500 Index that are classified as members of the GICS information technology sector. The S&P 500 Energy Index tracks companies in the S&P 500 Index that are classified as members of the GICS energy sector. It is not possible to invest directly in an index.
Diversification does not guarantee a profit or eliminate the risk of a loss.
Investing involves risks, including the potential loss of principal. A portfolio concentrated in one sector or that holds a limited number of securities may fluctuate more than a diversified portfolio. The fund’s strategies entail a high degree of risk. Leveraging, short positions, a non-diversified portfolio focused in a few sectors, and the use of hedging and derivatives greatly amplify the risk of potential loss and can increase costs. A non-diversified portfolio holds a limited number of securities, making it vulnerable to events affecting a single issuer. The stock prices of midsize and small companies can change more frequently and dramatically than those of large companies. Foreign investing, especially in emerging markets, has additional risks, such as currency and market volatility and political and social instability. Fixed-income investments are subject to interest-rate and credit risk; their value will normally decline as interest rates rise or if an issuer is unable or unwilling to make principal or interest payments. Investments in higher-yielding, lower-rated securities include a higher risk of default. The use of hedging and derivatives could produce disproportionate gains or losses and may increase costs. Liquidity—the extent to which a security may be sold or a derivative position closed without negatively affecting its market value, if at all—may be impaired by reduced trading volume, heightened volatility, rising interest rates, and other market conditions.