In order to create and sustain a successful investment program for our clients across multiple asset classes, it is necessary to have a deeply-rooted investment philosophy, a rigorous investment process supported by a set of manager selection and asset allocation criteria that flow logically from this philosophy and the right team in place to identify and select our investment partners. Our Q4 2014 InvestorView article, “BBH’s Approach to Manager Selection,” provides a detailed overview of our approach to allocating capital, our stringent set of criteria used in evaluating managers and our long-term objectives for our investment program. This piece serves as a solid backdrop to our approach to long/short investing.

We also believe it is critical to develop a well defined framework for investing in specific categories like long/short equity, and the investment team responsible for allocating our clients’ capital has endeavored to do this across other categories in the past. We hope that clearly communicating this framework and our approach to the long/short space will provide useful context about this complex area of the market, as well as our commitment to maintaining the same stringent standards we have for our more “traditional” managers.

What is Long/Short Equity?

Long/short equity is the oldest, most prevalent alternative portfolio management strategy. The concept dates back to 1949, when Alfred Winslow Jones established the world’s first hedge fund. The most basic definition of a long/short equity hedge fund is an investing strategy, used primarily by limited partnerships, that involves taking “long” positions in stocks that are expected to increase in value and “short” positions in those that are expected to decrease in value. Taking a long position in a stock simply means buying it – if the stock increases in value, the buyer will make money. On the other hand, taking a short position in a stock involves borrowing a stock one doesn’t own (usually from his or her broker), selling it, then hoping it declines in value, at which time one can buy it back at a lower price than he or she sold it for and subsequently return the borrowed shares. The goal of any equity long/short strategy is to minimize market exposure, generate alpha (risk-adjusted return over an applicable benchmark) on both the long and short side¹, protect capital during large market drawdowns due to the lower exposure and compound capital at attractive absolute rates of return over market cycles.

The Long/Short Landscape Today

In the first quarter of 2015, total hedge fund assets set a new record, surging to $2.94 trillion. For some perspective on the growth in the asset class, this total was a modest $30 billion in 1990. When isolating the equity hedged (long/short) space, overall assets have reached $820 billion today and represent the largest component of total hedge fund capital.² Based on the exponential growth of the market in terms of assets, number of managers and overall popularity, one can deduce that the space is much more competitive now than it was 25 years ago. Many knowledgeable participants in the long/short investing community would agree, with some even acknowledging that the growth in assets and talent has resulted in an overcapitalized market. This imbalance has led to significant challenges, most notably too many managers chasing too few ideas. As a result, there has been more “crowding” of names, particularly on the short side, leading to more correlated returns across managers, substandard returns relative to the past and inevitably overlapping trades eroding portfolio diversification benefits.

While the growth in the number of long/short managers has created real challenges for effectively executing a long/short strategy, it also has resulted in a wider talent gap between the exceptional manager and the average manager. In the case of long/short equity hedge funds, the average manager has underperformed comparable traditional asset classes during the 10-year period ending May 31, 2015. Over that period on an annualized basis, the HFRI Equity Hedge Index³ returned 5.20% versus 8.12% for the S&P 500. Furthermore, the last year in which the HFRI Index beat the S&P was in 2008, which was a year that can be taken with some ambivalence: While the index outperformed the S&P by almost 10 percentage points, the average “hedged” strategy still lost 27% that year.⁴ However, the dispersion of active management returns in long/short is substantial, as illustrated in the previous chart⁵, and top-quartile full-cycle results are compelling. Therefore, long/short selection represents not only a risk but also an opportunity – one that highlights the potential value exceptional managers can bring to our portfolios.

What Are the Attractive Characteristics of Long/Short Equity?

We believe many of the best investors in the world have chosen to manage capital in long/short hedge funds, and it is primarily the skill of these managers that attracts us to the long/short space. We understand the desire of a talented investor to manage capital in a long/short structure because of the objective to protect capital on the downside in order to compound capital at attractive equity-like rates of return over the long term. We believe this aligns with our core principle of protecting capital first, growing it second. Long/short strategies have the ability to use various hedging strategies to reduce market exposure (single name shorts, options and market hedges, for example). In a fairly valued market like the one we face today, we believe our clients will benefit from more “downside protected” strategies such as long/short. In sum, our goal with respect to long/short is quite simple: we are seeking to partner with highly experienced, exceptional stock pickers that have proven risk management capabilities and can generate equity-like returns (after taxes and after fees) over a full cycle while taking on less market risk. If executed correctly, a long/short investment enables us to maintain our equity positions in a wider range of market environments.

Further, it is no secret that long/short funds have lagged the market since 2009, and have received a fair amount of negative press for it. Considering that, a key objective of long/shorts is to manage risk (as defined by drawdown protection and the reduction of market exposure), so it is not surprising that they have underperformed the market. However, as noted, top quartile long/shorts have historically outperformed market indices over a full cycle, so having the appropriate long-term lens is necessary to evaluate managers’ investment merits correctly.

What Are the Challenges to Investing with Long/Short Managers?

There are two main challenges to partnering with a long/short manager: the difficult nature of “shorting” and the drag on returns from taxes and fees incurred by most long/short strategies.

The Difficult Nature of Short Investing: Superficially, shorting sounds quite easy to do. Bet against a lousy company or overvalued stock, watch the stock price fall and make a profit. On the contrary, there is no shortage of challenges when it comes to single name shorting. The practice is simply very hard to do well consistently, and has become more challenging over time as more capital has entered the shorting arena.

A few specific challenges to shorting include risk-return asymmetry and complexities in borrowing. In terms of asymmetry, potential gains on a short position are mathematically limited to 100% and potential losses are limitless, whereas with longs, the potential upside is limitless and potential downside limited to 100%. In addition, there is asymmetry in terms of position sizes – when an investor makes a mistake on the short side, the position grows and makes up a larger percentage of the portfolio, but when there is a mistake on the long side, the position size decreases. Another challenge relates to borrowing. When a long/short fund borrows a stock and sells it short, the fund provides the cash proceeds (plus a little extra) as collateral to the lender. The lender typically invests this cash and generates a return, and a portion of it is shared with the hedge fund. This “short rebate” is typically tied to the federal funds rate. With short-term interest rates so low, the rebates managers can earn on their short cash is extremely low, which make shares more expensive to borrow.⁶ While part of this negative carry issue is a temporary phenomenon due to the low interest rate environment, the increased demand for borrowing shares and the “crowding” of shorts due to the overall growth in the long/short space has proven to be more permanent. Additionally, a short investor can lose the terms of his or her borrow, meaning the counterparty can change the terms of borrowing during the manager’s hold period. Since crowded shorts are more susceptible to squeezes⁷, managers in these positions are forced to buy-in their shares if the loans on shares are called back. This tends to occur at the most inopportune time.

Shorting today is both more competitive and expensive than it has been in the past. Further, shorting is an incredibly difficult process due to broad market forces⁸, ⁹ as well as the highly technical nature of shorts. As successful hedge funds grow larger and larger, it becomes increasingly difficult for them to take large short positions in a security. Thus capacity constraints are an important consideration when partnering with a manager, as growing too large makes it challenging for managers to repeat past successes.

Taxes and Fees: We are always conscious of and focused on after-tax and after-fee returns. For taxable investors, strong pre-tax returns are nice to see, but it’s the money you take home after taxes that truly matters. The taxable nature of the gains is a key criterion as in other asset classes, but we pay particularly close attention to this dynamic with hedge funds because of how prevalent it is to find managers with high rates of turnover. A high turnover rate typically translates to high trading activity, a preponderance of short-term profits and consequentially higher tax rates on those gains. Generally speaking, the long/short universe is dominated by shorter-term oriented investing strategies with the average long investment having three- to 12-month time horizons, and short investments having one- to three-month time horizons. Compounding this short-term orientation problem is the fact that it is industry standard for hedge fund managers to be compensated on pre-tax returns, which can act as an incentive to make decisions that may be suboptimal for taxable investors. Lastly, a “short” investment pays the short-term capital gains tax on profits, regardless of how long the position is held.

More often than not, long/short investors do not justify their fees and tend to accumulate wealth off their client base irrespective of results. The required alpha to justify the standard “2 and 20” compensation structure is substantial. For example: a 20% gross-of-fee annual return from a long/short manager, on average, translates into an after-tax, after-fee return of approximately 12.2%, assuming a 2% management fee and 20% performance fee and assuming a tax efficiency ratio of 80%.¹⁰ For this reason, the bar is set higher with any potential long/short partnership we evaluate. In terms of our approach to fees, we look for value net of fees when examining a manager’s compensation structure. But, cheaper is not always better. We do believe there is a subset of long/short managers that have proven they justify their fees. While investment talent, process and returns are the obvious difference, other areas such as operational infrastructure, risk management and transparency combined can distinguish the best from the average. Additionally, as long-term investors, one way that we are open to reducing our fees is by taking advantage of fee concessions at the cost of reduced liquidity, generally in the form of a longer initial lock-up period.

BBH’s Criteria for Long/Short Investing

Investing in a long/short equity manager is not a declaration that we view the entire long/short space as attractive. While high-quality fundamental research and value orientation tends to be the standard within the long/short community, the overwhelming majority of long/short equity managers fall well short of the high bar we have established with our criteria. However, after expending significant attention and resources on this space, we believe we have found and will continue to find a very small minority of high-quality actors in the long/short population that meet our criteria and, most importantly, can enhance our client portfolios by providing diversification benefits and after-tax, after-fee returns that are competitive with our long-only managers. Based on the goals we seek to achieve with our long/short investments, we favor long-biased long/short strategies as opposed to more market-neutral or short-biased strategies. The investors that utilize this approach tend to be more philosophically aligned with our core principles. Further, there have been significant developments in the single name shorting environment over the past 15 years that make the practice extremely challenging today, and we prefer strategies that have more long than short exposure. Lastly, we believe being “net long,” or being exposed to the market over the long run, provides a higher likelihood of generating attractive, absolute, equity-like returns after-tax and over a full cycle versus market neutral or short-biased strategies.

The specific characteristics we look for in a long/short manager include:

• Long track records executing long/short strategy as a portfolio manager.
• Long-term oriented, business-owner mentality with time horizons compatible with our own and concentrated long books with multi-year holding periods.
• World-class investment research process with a proven ability to generate significant alpha on the long side while protecting capital in bear markets.¹¹ 
• Exceptional operational processes and infrastructure.
• Short book consistent with skills and prior experience, such as 100% single name shorts or a flexible approach using single name shorts, options strategies and other securities to inexpensively hedge long book and large tail risks (unlikely, catastrophic risks).
• Limited use of leverage.¹²
• Focus on downside protection and limiting drawdowns, but not at the expense of compounding capital at attractive rates over the long term.
• Treatment of clients as partners, which includes being transparent into what they own and why they own it.
• Alignment with investors, characterized by the vast majority of their net worth invested in the strategy, a willingness to cap assets at appropriate levels and a focus on one strategy.
• Unquestionable integrity, hunger, competitiveness, intellect, honesty and passion.

While long/short strategies have historically provided attractive diversification benefits to multi-asset portfolios, we view our allocations to the long/short space as entirely dependent on finding suitable long-term investment partners, largely due to the challenges in effectively executing a long/short strategy. Our default allocation to long/short equity is zero, whereas in the long-only world, we will have a permanent allocation. Because our team has the freedom to choose traditional investment structures over hedge fund structures, we also have the ability to wait for the best alternative managers to become available to our clients, as opposed to being forced to pick among the best managers available at a particular point in time. Although the best managers often have limited access for investors, they are most open to new capital when they see very attractive investment opportunities ahead. Other opportunities to partner with exceptional long/short managers are more “special situation” in nature, with the primary source coming from highly experienced portfolio managers spinning out of an existing firm or simply starting a new firm. These types of occurrences tend to be rare, and we seek to identify these situations opportunistically by leveraging our network to make sure we are in a position to get the “at-bat” so that we have a chance to “see the pitch.” When we invest with a manager that fits all of our criteria, we expect it to be a long duration partnership. Since we are looking to partner with managers that can generate equity-like returns over a full cycle, we will not be trading in and out of long/shorts based on the market environment. Instead we may modestly flex the individual position size up or down depending on the opportunity set or for rebalancing purposes. In circumstances in which we identify an inconsistent application of a manager’s process and approach (“style drift”), we will admit we made a mistake and exit the partnership without hesitation. We apply the same amount of rigor to the monitoring of our managers as we do to the underwriting of prospective managers.

Final Thoughts

We believe that partnering with select long/short managers who have the ability to compound capital at rates competitive with our long-only investment partners on an after-tax, after-fee basis can be attractive. While the population of managers that fit our criteria is exceedingly low, we have the ability to wait for the right managers at the right time, which is a key investing advantage. Unlike many asset allocators who succumb to the pressure to deploy assets in the alternatives category in order to look sophisticated, we are prepared to be patient, waiting for managers who share our core investment principles, who meet additional criteria we have for long/short investing and who we deem as exceptional.

We believe today is such a period when one needs to be more fearful than greedy. With equity valuations elevated and the potential for rising rates to wipe out fixed income gains quickly, we believe an allocation to a long/short strategy that provides a more defensive equity position is prudent.