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.