Car Fires and Long/Short Equity

Bob Elliott wrote a blog post in support of the new Unlimited Equity Long/Short ETF (HFEQ). HFEQ uses a replication process, this from the blog post spells out the logic.

Many allocators eschew the concept of low-cost alpha indexing approaches like what is described above with the hope that they can find individual managers that will outperform their peers.  But over time, a lower cost indexing approach to investing in managers creates a higher probability outperformance relative to peers. That is a product of the inherent diversification benefits of an index approach which can improve return consistency, paired with a lower fee structure allowing the investor to harvest more of the alpha generated.

I don't think I have a nit pick with the idea but obviously a replication of something will at times be right in line, lag at other times and come out ahead in other periods. We see this with the various managed futures replicators. This reality is neither negative nor positive but more about having the correct expectations. 

Here are a couple of performance tables of what Bob is talking about, notice the different time frames.

The annualized outperformance is greater from the period starting in 2002 so the version of long/short that Bob is talking about was very additive during the "lost decade," less so since then as equities have done much better than in the 2000s. 

Related is a link from Crystal Capital Partners that gives a little more details abput different kinds of long short in the context of trying to sell some sort of hedge fund access. Yes, it is a salesy piece but there is some information there too. 

The starting point from Crystal is that the change in the inflationary outlook that hurt bonds in 2022 and persists today has diluted the diversification benefits of the plain vanilla 60/40 portfolio. They took quick, but useful, looks at pairs trading (statistical arbitrage), mean reversions (their look was a little narrower than we've looked at previously) and merger arbitrage which we look at constantly.

By utilizing strategies that have minimal exposure to inflationary pressures, quantitative hedge funds have been a steady pillar in investors’ portfolios amidst periods of market turmoil. A group of 53 quantitative hedge funds measured by Goldman Sachs’s prime-brokerage unit delivered annualized returns to investors of 9.9% over the past 5 years with minimal volatility and nearly no correlation to the broader stock market

I would not get hung up on the use of 'quantitative hedge fund' and instead think about these as tools targeting specific outcomes to be evaluated based on whether they deliver on their intended outcomes. 

The equity market has of course rocketed off the April low so it makes sense that the short bias long/short strategy would go down. Absolute return long/short has been successfully immune from all the volatility and the long bias long/short has generally captured the rocketing. The one that can switch its bias is probably a tougher hold, that's not a fund I've ever considered but with something like that, its investors probably need to hold on no matter what.

To extent these strategies are tools, you need to use the right tool. Just as a short bias fund is likely to go down when stocks are rallying, I wouldn't count on a long bias fund to go up when stocks are falling. A long bias fund certainly could but I would not expect it. 

A quick fire department analogy that might fit with knowing what tool to choose. A little after midnight last night, we got dispatched out for an vehicle accident in between our service area headed out of Walker and Prescott Fire Department's service area. We were a little closer but shortening the story, the ambulance company got there before we did. Right before I got to the station house, our dispatcher said the ambulance company was already there. 

I was second to arrive at the station house and our ambulance was already out, ready to go. Knowing there was already an ambulance there, I made the decision to take one of our engines (a fire truck) instead. We were not going to be providing medical care in this scenario but if the accident scene was a little more complicated than had been called in, we'd be able to address the situation more directly. 

We're getting to the end of the call, the sheriff released us (it was their scene, they were in command) and just as we're starting to roll, flames started coming out of the crumpled hood. We ran a line down the embankment and were able to put out in a few minutes. I processed the information I had and decided what tool would give us more optionality for the circumstance. It would have been awkward to have been there, have the car catch fire and the fire department not able to do much about it, not sure one fire extinguisher would have been enough compared to the 100 or so gallons we sprayed on it. 

The information, analysis and opinions expressed herein reflect our judgment and opinions as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation.