The Promise and Peril of Long-Short Equity Funds

This analyst blog is part of our coverage of the 2016 Morningstar Investment Conference.

In a panel discussion at the Morningstar Investment Conference, portfolio managers from Diamond Hill, PIMCO, and Boston Partners discussed the varying approaches and struggles in managing long-short equity strategies, as well as their team's process in finding stock to short and how they mitigate against the inevitable risks of shorting.

The panel moderator, Morningstar's Josh Charlson, began the conversation by highlighting the notable increase in long-short equity funds in recent years, as well as the wide dispersion in performance among these funds. Charlson also noted that managers within the Morningstar category have many different approaches in gaining their net exposure to the market.

Differences in approach were apparent among the panelists. Geoffrey Johnson, portfolio manager for PIMCO's long/short active equity strategy explained that his strategy follows a bottom up approach which allows for varying degrees of exposure to both long and short equity. Johnson's strategy could very well end up looking like a long-only fund at times and his team does not initiate short positions if they cannot find good ideas. Furthermore, PIMCO's team will accept holding cash during times where they do not see the benefit in being invested at all. In contrast to PIMCO, Ric Dillion, portfolio manager for Diamond Hill Long-Short, noted that his team follows a more constrained approach, while Josh Jones of Boston Partners explained that his strategy aims to be fully invested.

Next, Charlson asked our panelists if they thought the struggles in the long-short equity space can be attributed to market conditions or whether it was a matter of manager skill. Jones noted that the long-running and strong bull market has been one factor contributing to the weakness in long-short equity. Jones stated that another potential factor has been quantitative easing policies which have supported asset prices and led to multiple expansion in equities. Jones explained these policies have further led to defensive businesses being in favor and to the strong performance of low volatility equity funds which are now trading higher multiples. Overall, Jones noted this market environment has made it difficult for both long-only and long-short active managers to outperform.

The task of shorting a stock is no easy feat, therefore, the panel next discussed how they go about searching for a short idea. Dillion said his team of 30 investment professionals tries to understand which stocks are the winners and losers in a given industry. Furthermore, his team aims to identify how their views are different from consensus opinion. Jones said compared with the process of finding long ideas, finding short ideas is a more difficult task, however he noted that the use of quantitative tools is especially helpful when searching for a stock to short.

As the risks with shorting are high, Charlson asked the panel what approach they take in mitigating such risks. The message was somewhat consistent across the panel, as the portfolio managers emphasized the importance of sizing a short position. The panelists also said they mitigate against risks by constantly revisiting and revaluating the investment theses for short positions.