A New Era for Long/Short Fundamental Equity
Examining the forces behind the challenging environment for fundamental equity long/short strategies, and how successful players can respond.
The last two years have been tumultuous for fundamental equity long/short strategies. Last year’s returns for the industry were the worst since 2011, causing many hedge fund legends to shut their doors[1].
These outcomes are troubling, and they are not a short-term phenomenon either. Rather, they are only the latest evidence in a decade-long decline for the industry.
What’s going on? Consider this culinary analogy:
1. There are more mouths (hedge fund managers),
2. Eating a smaller pie (aggregate alpha in the industry),
3. Made of fewer ingredients (stocks).
This combination does not make for a tasty dessert.
More Mouths
Figure 1 shows how the number of hedge fund managers tracked by Novus’ proprietary classification methodology (via public filings), or HFU, has risen over the last 14 years.
Figure 1: Managers in the Novus Hedge Fund Universe (Note: The HFU is comprised primarily of ELS-focused hedge funds)
While growth has slowed since 2010, the number of funds has more than doubled over the period, as more fund managers were lured into the profit potential of one of the highest-margin industries in the world.
Smaller Pie
Figure 2 depicts how the aggregate alpha of the industry (measured as the yearly outperformance of a pool of securities held by hedge funds) has steadily declined over the years.
Figure 2: Hedge Fund Alpha (bps represent aggregate alpha as per 6-factor model of the Novus Hedge Fund Universe)
This result should come as no surprise: a sustainable information edge is needed to achieve long-lasting outperformance. As information becomes instantaneously and ubiquitously available, the plausibility of a sustained information edge begins to weaken.
Fewer Ingredients
There are fewer stocks today than there were ten years ago. From Figure 3, we can see how the number of securities in Novus’ Hedge Fund Universe has shrunk since 2004, as companies increasingly stay private, businesses close, and mergers and acquisitions sky-rocket.
Figure 3: Securities Held by the Novus Hedge Fund Universe
If you recall our observations in a previous post about the Fundamental Law of Active Management, a smaller number of available bets lowers the capability for a manager to deliver alpha.
What is to be done?
Despite the alarming story told by the graphs above, few fund managers out there are responding effectively to this new era. Here’s how they can re-kindle their business model to adapt to the hedge fund environment of the future.
Re-discover information edges
The revolution in sell-side research business models and the shrinking of the talent pool in the industry are leaving more securities uncovered from a research perspective, which leads to more opportunities for information edges.
Unbundle picking from construction
About 50% of the alpha of top quintile managers working with Novus comes from skill in portfolio construction (managing what you select) versus stock picking (selecting what to manage). And yet 82% of investment teams’ efforts are devoted to stock research (Source: Novus survey across 56 fundamental equity long/short managers). This suggests a clear arbitrage opportunity.
Moreover, portfolio managers who have fully embraced their job title—thus fully relinquishing their previous duties as stock analysts—tend to perform better. One of Novus’ closely monitored managers steadily delivers 900 bps of alpha p.y. through portfolio construction, simply by focusing on how to combine ideas researched by his analyst teams, as opposed to doing that research himself.
Embrace actionable transparency
Managers who embrace transparency as a competitive edge are achieving faster AUM growth. As an industry, we’ve moved (thankfully) very far from the early days when transparency was considered the hedge fund manager’s anathema. And we’ve also made progress in transforming the transparency boom coming out of 2008 (fueled by fear and need for control) into a competitive edge.
Transparency is comforting for allocators who want to ensure that managers are sticking to their process. An allocator will forgive a manager who’s going through tough times while maintaining consistency with their discipline. On the other hand, we’ve also seen allocators redeem immediately after discovering that a recent outperformance streak was fueled by a deviation from a manager’s stated process.
The long/short equity puzzle is complex, but it’s a puzzle worth solving. We’ll continue breaking this topic down in future posts.
Footnotes
[1] Leon Cooperman’s Omega Capital, Highfields Capital Management, Criterion Capital Management, Jason Karp’s Tourbillion Capital Partners, Jabre Capital Partners featured among prominent closures in 2018, while John Griffin’s BlueRidge, Eric Mindich’s Eaton Park, and many others feature among 2017 closures.