Long/short equity strategy can safeguard against drop

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Opinion

New Zealand's current investment backdrop is one which has seen a significant increase in asset values (including across shares, bonds and property), as well as some unusual activity in respect of asset correlation.

These factors have made it increasingly difficult for investors to find strategies to help safeguard their position against a market downturn, other than an over-allocation to cash.

In an environment such as this, investors could consider the merits of an equity long/short investment strategy as part of their overall asset allocation.

The strategy is not a new one, whereby investors look to develop a market neutralportfolio that will deliver positive absolute returns irrespective of the market environment.

A long/short investment strategy is built around two core activities:

• Investors will hold a number of "long-only securities" - where equities are purchased in a conventional manner, and are then owned by the investor - sometimes referred to as "long" investments.

• Short selling, by contrast, involves the investor paying someone to borrow their shares for a period of time. Returns are generated by selling these borrowed shares with the intention of buying the shares back later at a lower price, and returning them to the lender.

Simply put, a long/short strategy will see a combination of investing in stocks that are expected to appreciate over time, against short positions in stocks that are expected to decline.

Within the context of the New Zealand equity market, shorting stocks has been somewhat difficult in recent times given the strong upward trend.

However, if we consider a specific stock such as Fletcher Building for example, it's possible to argue that the recent resilience in the share price is at odds with the magnitude of the earnings downgrades.

In cases such as this, an alternative approach could be not to hold the stock, but to 'short' it on the basis that you will be able to buy it back at lower levels; and effectively close out your position at that point.

To illustrate this point, an investor may sell their security at $8 on the premise that earnings downgrades will continue to weigh on the equity price - which will then allow them to purchase the stock back at a later point for approximately $7, and therefore collect the difference.

If equities are underperforming, bonds will hopefully be outperforming - so a balanced portfolio should protect you in times of real market stress.

In fact, this strategy can provide less volatility as well as broader diversification when compared with a long-only equity fund.

A long/short allocation backed by an investment team committed to a clearly defined strategy can provide outcomes for investors that do differ to market returns, and especially so in contrast to the allocation to exchange traded funds and passive strategies.

Long/short investment strategies should however be considered as more of an 'add on' or supplementary approach to a diversified portfolio strategy, particularly when considering where we are currently in the cycle.

In an investable universe that has seen a 'flood of money' blindly buying a basket of securities, this actively managed strategy provides a complement for investors looking for a market neutral approach.

Mark Fowler is Head of Fixed Income at Hobson Wealth Partners

Disclaimer: This article does not consider objectives or situation of any particular investor. It should not be construed as a solicitation to buy or sell any security or product, or to engage in or refrain from engaging in any transaction. We recommend that you consider the appropriateness of information to your situation and obtain financial, legal and taxation advice before making any financial investment decision.