Institutional Investor's Alpha Magazine - March 2009 - (Page 50) Long-Short Equity be. “A long-short equity strategy is perfectly positioned,” he asserts. But even when conditions are ideal, long-short investing is tricky. “If you adjust the returns of long-biased long-short managers for risk, it becomes hard to understand why investors shouldn’t just buy the S&P index,” says Anurag Sanyal, co–portfolio manager at Sequence Capital, a Skeptics remain, however. Marco Battaglia, chief executive officer and founder of Temujin Fund Management, a New York–based zero-market-exposure long-short equity hedge fund firm with about $370 million in assets under management, is among those who question whether long-biased managers deliver what they promise. “The industry in general did a good job protecting capital in the past year by cutting net exposure,” he says, “but it was out of necessity. Their net exposure was driving returns, and it illustrated that, for the most part, they have been selling beta rather than alpha.” Battaglia — whose Temujin Fund was down 11 percent in 2008 — says long-short managers often hedge a big part of their portfolio using exchange-traded funds, which by definition move with the market, rather than shorting individual stocks, which can actually deliver alpha. Prudence dictates that managers keep short positions smaller than longs because shorts carry bigger potential losses, typically close out quicker and require much more work than longs do. “A fundamental manager has to spend double or triple the amount of time researching the short side relative to the long side to construct a truly marketneutral portfolio,” Battaglia notes. His firm uses quantitative screening — assessing factors like leverage, profit margins and free cash flow — to narrow choices and then drills into the fundamentals of the most promising equities on both sides of its portfolio. Like most long-short funds, Temujin skews its investments toward a few stocks: The ten biggest long positions typically account for half the firm’s net asset value and may be held for a year or more; the rest of the portfolio runs to several hundred names and turns over about twice a year. Each small position typically represents 50 basis points or less of total assets. Here, Battaglia relies heavily on quantitative analysis rather than deep research. “It doesn’t make sense to study a company in depth if you are looking for 2 percent alpha to play out over a couple of months,” he says. He argues that the spectacular performance of longshort managers during the 2000–’02 bear market was an aberration. The old-economy value stocks they favored as long positions had been left in the dust during the great Internet boom, and when that bubble burst, managers made a killing by shorting overvalued tech stocks. “It was like shooting fish in a barrel if you were a fundamental long-short manager,” Battaglia says. Now, he adds, “it’s going to be hitting singles and doubles with modest net exposure to get to 15 percent. The current generation is largely untested in being able to do that.” Sequence Capital, founded in 2005 by Sanyal and his portfolio co-manager, Jennifer Klein, has made money in each of its three years. It focuses on four sectors: retail, business services, technology and industrials. Sanyal and Klein won’t consider a stock until they have tracked the company for at least three quarters; they have followed most stocks in their portfolio for years. In addition to studying financial statements, they create models to “Some of the research is hard numbers, some is qualitative, and then there’s an element of judgment.” — JENNIFER KLEIN, SEQUENCE CAPITAL $300 million New York–based long-short equity firm that relies on fundamental research to build its portfolio. Sequence is among the select few long-short firms that were up in 2008 — posting a 4 percent net return. Sequence keeps its net market exposure — its longs minus it shorts — to no more than 10 percent of its portfolio’s total asset value. Most long-short equity managers have a net long bias. But William Knight, co-founder of Pacific Alternative Asset Management Co., a $9 billion fund of hedge funds based in Irvine, California, says the composite portfolio of Paamco’s long-short managers has a net market exposure that varies over time — from 20 percent to 40 percent — rising when the market goes up and shrinking when it falls. It’s a dicey game. Among those who suffered in 2008 were well-known long-short firms like Lone Pine Capital in Greenwich, Connecticut, New York–headquartered Maverick Capital (its flagship fund was down about 28 percent through mid-December) and Greenwich-based Tontine Associates, which pulled the plug on two funds after they lost a big chunk of their net asset value in October alone. This was because the three firms had either unusually high net long exposure or unusually poor stock picks last year. Knight stresses that the majority of longshort managers, in addition to delivering higher returns, had lower volatility than did market indexes — precisely what investors should expect from the strategy. And though institutional investors and hedge funds that have cash are sitting on the sidelines until the cycle of liquidations and redemptions runs its course, they won’t stay out of the game forever. “The stock picker’s time will come again — when the market settles down,” Knight says. “Managers are finding incredibly compelling deals out there. Lots of companies have more cash on the books than their market capitalization. They are trading well below fair value.” 50 • INSTITUTIONAL INVESTOR’S ALPHA • MARCH 2009
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